Solution Manual For Principles of Economics, A Streamlined Approach, 4th Edition Robert Frank, Ben B

Solution Manual For Principles of Economics, A Streamlined Approach, 4th Edition Robert Frank, Ben Bernanke, Kate Antonovics and Ori Heffetz Chapter 1-21

CHAPTER 1 THINKING LIKE AN ECONOMIST Answers to Review Questions 1. Your friend probably means that the benefits from private solo lessons are greater (your tennis game will improve faster) than if you take group lessons. But private lessons are also more costly than group lessons. So those people who don‘t care that much about how rapidly they improve may do better to take group lessons and spend what they save on other things.

2. False. According to the Cost-Benefit Principle, your willingness to make the trip should depend only on whether $30 is more or less than the cost of driving downtown.

3. Because the price of a movie ticket is a cost the patron must pay explicitly, it tends to be more noticeable than the money that he or she would fail to earn by seeing the movie. As Sherlock Holmes recognized, it‘s easier to notice that a dog has barked than that it has failed to bark.

4. Using a frequent flyer coupon for one trip usually means not having one available to use for another. By thinking of frequent-flyer travel as free, people fail to consider the opportunity cost of using the coupon, thereby making wasteful travel decisions.

5. Your tuition payment is a sunk cost as long as it is non-refundable, since the payment cannot be recovered even if you drop out of school. If the payment is refundable until a certain date, it is not a sunk cost until after that date.

Answers to Problems 1. It could be that most students are aware that there are other, more important, uses of the school's $20 million. Because resources are scarce, having more of one thing necessarily means having less of another. If the school spends $20 million on a new recreation facility, then it will have $20 million less to spend on other projects, such as additional student housing. If the value to students of those alternate projects is greater than the value they place on the new recreation facility, then they would rationally vote "no."

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2. The economic surplus from washing your dirty car is the difference between the benefit you receive from doing so ($6) minus your cost of doing the job ($3.50), or $2.50.

3. The marginal benefit of adding a pound of compost is the extra revenue you earn from the additional pound of tomatoes grown. Therefore, you should continue to add more compost as long as the marginal benefit exceeds or equals the marginal cost of adding another pound of compost ($0.50). This type of problem is best answered using a table such as the one below.

Note that by adding the fourth pound of compost, you’ll get an additional 2 pounds of tomatoes, or $0.60 in extra revenue, which covers the $0.50 cost of the extra pound of compost. However, adding a fifth pound of compost yields only 1 additional pound of tomatoes, so revenue increases by only $0.30, which is less than the $0.50 cost of the additional pound of compost. Therefore, you should add 4 pounds of compost and no more.

Pounds of compost

Pounds of tomatoes

Extra pounds of tomatoes

0 1 2 3 4 5 6

100 120 125 128 130 131 131.5

20 5 3 2 1 .5

Extra revenue or marginal benefit $6.00 $1.50 $0.90 $0.60 $0.30 $0.15

Extra or marginal cost $0.50 $0.50 $0.50 $0.50 $0.50 $0.50

4. In applying the cost-benefit principle, you should only consider the costs that change with your decision. Since you have already bought your ticket, the $30 you spent on it is a sunk cost. It is money you cannot recover, whether or not you go to the game. Thus, in deciding whether to see the game, you should compare the benefit of seeing the game (as measured by the largest dollar amount you would be willing to pay to see it) to only those additional costs you must incur to see the game (the opportunity cost of your time, whatever cost you assign to driving through the snowstorm, etc.).

Jamal, too, must weigh the opportunity cost of his time and the hassle of the drive in deciding whether to attend the game. But he must also consider the $25 he will have to spend for his ticket. At the moment of deciding, therefore, the remaining costs Jamal must incur to see the game are $25 higher than the remaining costs for you. And since you have identical tastes—that is, your respective benefits of attending the game are exactly the same—Jamal should be less likely to make the trip. You might think the cost of seeing the game is higher for you, since your ticket cost $30, whereas Jamal’s will cost only $25. But at the decisionmaking moment, only the ticket cost for Jamal ($25) changes whether he goes or not, and is therefore the only cost that should be considered.

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5. If Kenya kept the $200 and invested it in additional mushrooms, at the end of a year's time she would have $400 worth of mushrooms to sell. Therefore, Fatima must give Kenya $200 in interest in order for Kenya not to lose money on the loan.

6. Even though you earned four times as many points from the first question than from the second, the last few seconds you spent on question 2 added more points to your score than did the last few seconds you spent on question 1. This suggests that if you spent a little more time on question 2 and a little less time on question 1, then you‘d get more extra points on question 2 than you‘d lose on question 1.

7. According to the cost-benefit principle, the two women should make the same decision.

After all, the benefit of seeing the play is the same in both cases, and the cost of seeing the play—at the moment each must decide—is exactly $10. Some may think that in the case of the lost ticket the cost of seeing the play is not $10 but $20, the price of two tickets.

However, in terms of the financial consequences, the loss of a ticket is clearly no different from the loss of a $10 bill. Both of these are examples of a sunk cost, as the $10 is lost whether one attends the play or not. So in each case, the question is whether seeing the play is worth spending $10. If it is worth $10 to see the play, both Monica and Rachel should see it; otherwise they should not attend the performance. Whichever your answer, it must be the same for both Monica and Rachel.

8. In the current system, the cost is $6 per week no matter how many cans you put out, so the cost of disposing of an extra can of garbage (the marginal cost) is $0. Under the tag system, the cost of putting out an extra can is $2, regardless of the number of the cans. Since the marginal cost of putting out cans is higher under the tag system while the marginal benefit remains the same, we would expect this system to reduce the number of cans collected.

9. At both houses, the cost of drinking a cola is that it‘s not available to drink later, but at the Hector‘s house, this cost is low because your sibling may drink the cola before the other is able to. This gives each of Hector‘s children a strong incentive to consume the colas now. Jin, by contrast, has eliminated this incentive by not allowing either child to drink more than half the colas. As a result, his children can consume the cola at a slower, more enjoyable pace.

10. If Adriana is rational, she continues each scooter ride as long as the marginal benefit of riding a little longer is greater than the marginal cost. Her usage pattern under the current plan tells us that Adriana values the tenth minute of each ride at no less than its marginal cost, 20 cents. For a 10-minute ride, both plans charge exactly the same amount, $2. But at that point, under the new plan, the marginal cost is only 10 cents per minute. And since her benefit of riding an additional minute is the same under both plans, she's likely to take longer rides under the new plan.

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11. At University A, the marginal or extra cost for each additional pound of food is $0, so everybody will keep eating until the extra benefit from eating an extra pound is also equal to $0. At University B, however, the cost of eating an extra pound of food is $2, so people will stop eating when the benefit of eating an extra pound falls to $2. Food consumption will thus be higher at University A.

CHAPTER 2 SUPPLY AND DEMAND Answers to Review Questions 1. Under the horizontal interpretation, we begin with a price for the good and then use the demand curve to read the quantity demanded at that price on the horizontal axis. Under the vertical interpretation, we start with a quantity produced and use the demand curve to read the marginal buyer‘s reservation price for the product on the vertical axis.

2. The equilibrium price of a good is determined by the intersection of its supply and demand curves. We can know everything about a good‘s cost of production (that is we can know its supply curve exactly) but without the demand curve we will not know the quantity people will want to purchase and therefore we will not know what price must be charged to cover the cost.

3. If price control regulation prevented the price of gasoline from rising to its equilibrium level, we would expect to see symptoms of excess demand for gasoline such as lines of cars waiting at the pumps to buy gas.

4. A change in demand means a shift of the entire demand curve, whereas a change in the quantity demanded means a movement along the demand curve in response to a change in price of that specific good.

5. It is smart for each individual at a sporting event to stand up in order to get a better view of the game. However, it is dumb for all to stand up since no one sees any better than if all had remained seated.

Answers to Problems 1. a. The supply curve would shift to the right. The discovery is a technological improvement, so the improved technique would allow a farmer to use the same

inputs

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to produce more corn. b. The supply curve would shift to the right. Fertilizer is an input into the production of corn, so this is an example of a decrease in an input price. A decrease in input prices shifts the supply curve to the right. c. The supply curve would shift to the right. New tax breaks make farming relatively more profitable than before, so those who were earning an income from a non-farming job that paid just a little bit more than farming would switch to farming if the tax break is big enough. d. The supply curve would shift to the left. A tornado would destroy corn fields along with infrastructure used to harvest and store it. Thus, at every given price, the quantity of corn supplied would be lower and the supply curve shifts to the left.

2. a. The demand curve would shift to the right. Buyer income has risen and vacations are normal good, so this increases the quantity demanded at every given price.

a

b. The demand curve would shift to the left. Buyer preference will probably change because most people want to avoid foods that cause heart disease, so buyers will purchase fewer pizzas with pepperoni. c. The demand curve would shift to the right. Since these goods are substitutes, an increase in the price of electric cars would result in an increased demand for gaspowered cars. d. The demand curve would remain unchanged. An increase in the price of electric cars decreases the quantity demanded of electric cars, which causes movement along the demand curve.

3. The supply of binoculars will not be affected. The demand for binoculars might increase due to more people wanting to spot UFOs. This will lead to an increase in the equilibrium price of binoculars and the quantity of binoculars supplied. However, no change in the supply of binoculars should occur since nothing has changed with regard to input prices, technology, or any of the factors that determine supply.

4. At a price of $4.50 per gallon, there is excess supply in the market (since 3,860 is greater than 3,250). This excess supply will exert a downward pressure on prices, leading the equilibrium price to fall below $4.50 per gallon.

5. Two goods are complements if an increase in the price of one causes a leftward shift in the demand curve for the other (or if a decrease in the price of one causes a rightward shift in the 5 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

demand curve for the other). The opposite holds true if two goods are substitutes, where an increase in the price change of one causes a rightward shift in the demand curve for the other (or a decrease in the price of one causes a leftward shift in the demand curve for the other). a. Since washing machines and dryers are typically used together, we would expect them to be complements. b. Since tennis rackets and tennis balls are typically used together, we would expect them to be complements. c. Since birthday cake and birthday candles are typically used together, we would them to be complements.

expect

d. Since cloth diapers and disposable diapers are generally consumed in place of one another, we would expect them to be substitutes.

6. An increase in the birth rate will increase the population of potential buyers of land. This will shift the demand curve for land to the right and increase the equilibrium price of land.

7. An increase in the price of chicken feed shifts the supply curve of chickens to the left, resulting in an increase in the equilibrium price of chickens. Assuming that chicken is a substitute for beef, the increase in the price of chickens will shift the demand curve for beef to the right, increasing both the equilibrium price and the equilibrium quantity of beef.

8. Automobile insurance and automobiles are complements, so an increase in automobile insurance rates will thus shift the demand curve for automobiles to the left. Some people who would have bought new automobiles with the lower insurance rates will choose instead to purchase a used car, use public transportation, or perhaps continue driving their current vehicle.

9. a. The discovery will shift the demand curve for oranges to the right. As a result, both the equilibrium price and the equilibrium quantity of oranges will increase. b. Since grapefruit can be assumed to be a substitute for oranges for most consumers, a drastic decrease in the price of grapefruit will make some of the current orange consumers buy grapefruit instead. This will shift the demand curve of oranges to the left.

As a result, both the equilibrium price and equilibrium quantity of oranges will decrease. c. Since labor is an input to orange production, an increase in the wage is an increase in the cost of an input. This will shift the supply curve of oranges to the left. As a result, the equilibrium price of oranges will increase and the equilibrium quantity will decrease.

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Note that an increase in wages does not automatically mean an increase in the productivity of the workers, which would have affected supply in the opposite direction. d. A better than expected harvest means that supply will be greater, shown graphically as a shift of the supply curve to the right. As result, the equilibrium price of oranges will decrease and the equilibrium quantity of oranges will increase.

10. The mad cow disease announcement is likely to cause many consumers to substitute chicken for beef; this will cause the demand curve for chicken to shift to the right. The discovery of the new chicken breed will cause a rightward shift in the supply curve of chicken. The two developments together will increase the equilibrium quantity of chicken sold in the United States, but we cannot determine the net effect on equilibrium price from the information given.

11. Since both the demand and supply curves for tofu have shifted outward, the equilibrium quantity of tofu sold is higher than before.

The equilibrium price could be higher (left panel), or lower (right panel), or it could remain the same, depending on the size of the shifts in supply and demand. If the increase in supply is small relative to the price increase in demand, price will rise. If the increase in supply and the increase in demand exactly offset each other, price will not change.

Price ($/lb)

Price ($/lb)

S

P'

P

P

P' S

D'

S' Q'

S'

S

D' D

S'

D Q

S

S'

Millions of lbs per month

Q

Q' Millions of lbs per month

12. a. Sometimes true b. Sometimes true c. Always true

13. The abrupt reduction in travel during the COVID-19 pandemic led to a sharp decrease (leftward shift) in the demand for crude oil since it is a primary ingredient in the production of gasoline and jet fuel. At the same time, the increase in the production of crude oil led to an increase (rightward shift) in supply. Both the decrease in demand and the 7 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

increase in supply worked to lower the equilibrium price of crude oil. The net effect on the equilibrium quantity, however, depends on the relative magnitude of the shifts in supply and demand. In the accompanying figure, the demand shift dominates, so the equilibrium quantity falls. If the supply shift had dominated, equilibrium quantity would have increased.

CHAPTER 3 DEMAND AND ELASTICITY Answers to Review Questions 1. To say that someone needs a good is to suggest that he cannot choose to do without the good or buy a substitute for it. We are more likely to be mindful of the fact that almost all goods have substitutes if we speak of wants rather than needs.

2. A scarce good must be rationed in one way or another. If its monetary price is zero, people will either have to wait in line for it, as in the free ice cream example or incur some other cost to gain access to it.

3. A consumer‘s price elasticity of demand for a good depends on the fraction of the consumer‘s income spent on that good because a price change alters the real value of the consumer‘s purchasing power. This effect grows larger as the share of the consumer‘s budget spent on a good increases.

4. Elasticity of demand at any point is the price-quantity ratio at that point times the reciprocal of the slope of the demand curve. The slope, and hence its reciprocal, is constant along a 8 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

straight-line demand curve, but the price quantity ratio—and hence price elasticity of demand—declines as we move down the curve.

5. In order for total spending to fall, the percentage increase in price must be smaller than the percentage decrease in the quantity demanded. This implies that the price elasticity of demand must be elastic since in this case a one percent increase in price causes a more than one percent decrease in quantity demanded.

6. The algebraic sign of the elasticity of demand for a good with respect to its own price conveys no useful information because it is always negative. By contrast, the elasticity of demand for a good with respect to the price of another good can be either positive or negative depending on whether the goods are substitutes or complements, so it is important to keep track of the sign in this case.

Answers to Problems 1. Peer influence provides an example of how social forces often influence demand; it is often the most important single determinant of demand. A change in cost is a supply-side influence that will shift supply and not affect reservation price. A change in the price moves the consumer along the demand curve and does not affect reservation price.

2. We would expect patrons of the gourmet restaurant to have higher incomes, on average, than patrons of the diner, since the willingness to pay for high quality food is likely to increase with higher income. Likewise, the willingness to pay for service is also likely to increase with higher income. Since people tend to leave tips of about 15 percent of the prices of their restaurant meals, gourmet restaurant patrons actually pay for higher service quality, and are therefore more likely to receive it.

3. No. Even at twice the original price, the marginal benefit of each of the twenty train trips may be higher than the marginal cost of each trip, even when including the implicit costs of a trip such the best alternative use for the money spent. After all, missing a trip implies missing an entire day‘s work.

4. The market demand curve (right panel) is the horizontal summation of the two individual demand curves (left and center panels).

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Price ($/ticket)

Price ($/ticket) 36

Price ($/ticket) 36

24

24

24

12

12

12

96

tickets/yr

16

48

tickets/yr

16

80

tickets/yr 144

5. The price elasticity of a good generally increases with the number of available substitutes for the good. It is easier to substitute a Ford or Toyota for a Chevrolet than it is to substitute a motorcycle or a skateboard for a car. Thus, the market demand curve for cars is likely to be less elastic with respect to price than the market demand curve for Chevrolets or any specific car brand.

6. For the demand curve shown, the slope is 1 so 1/slope is also 1. The absolute value of the price elasticity of demand at any point on this demand curve is thus the ratio (P/Q) at that point.

Point Elasticity infinity A 3 B 1 C 1/3 D 0 E 7. a. See graph below:

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b.

The formula for calculating the price elasticity of demand is

A 

P 1  Q slope

Substituting P = 4, Q = 6 and slope is 1/3, we have

4 1 2  3  2 6 1 3   3

A  

c.

Total revenue equals P × Q. Thus, if the price per package increases from $4 to $5, total revenue will fall from $24,000 to $15,000.

d.

Using the same formula as in part b:

A 

1 1 1    3  0.2 15  1  15    3

e. Total revenue equals P × Q. Thus, if the price per package increases from $1 to $2, total revenue will rise from $15,000 to $24,000.

8. Along any straight-line demand curve, the elasticity of demand is greater than 1 (demand is elastic) at any price and quantity combination above the midpoint, and the elasticity of 11 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

demand is less than 1 (demand is inelastic) at any price and quantity combination below the midpoint. At the midpoint, the price elasticity of demand is equal to 1 (demand is unit elastic). Revenue is maximized when demand is unit elastic. Thus, the price should be set at the midpoint of the demand curve ($6 per visit).

P ($/visit) 12 elastic region 6 inelastic region 3

Q (visitors per day)

6

9. What government officials failed to take into account was that people don‘t demand electricity for its own sake, but rather as a means to accomplish other ends such as producing cooler air for their homes. By requiring people to buy more efficient air conditioners, the government effectively reduced the price of buying cooler air. If the demand for cool air is sufficiently elastic with respect to price, people may buy so much more of it that they end up using more electricity.

10. The cross-price elasticity is percent change in Q syrup percent change in Pmilk



4  2 2

Since this cross elasticity is negative, the two are complements.

CHAPTER 4 PERFECTLY COMPETITIVE SUPPLY Answers to Review Questions 1.

The least costly options should be exploited first, with more costly options taken up only after the least costly ones have been exhausted. At low prices, only those with low 12

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opportunity costs of producing the product would find it worthwhile to offer it for sale. As prices rise, others with higher opportunity cost could profitably enter the market.

2.

If a perfectly competitive firm charges even a few cents above the prevailing equilibrium price, no buyer will purchase the firm‘s product because buyers can always purchase the product from another firm (since all firms in a perfectly competitive market sell the same standardized product). In addition, since each firm in a perfectly competitive market sells only a small fraction of the total quantity exchanged, no single firm can influence the market price, and a firm that charges the prevailing equilibrium price can sell as much as it wishes. As a result, a perfectly competitive firm‘s demand curve is a horizontal line at the equilibrium price.

3.

It can take months or years to rent or build a new factory. By contrast, additional production workers can be hired in days or weeks. The factory is therefore far more likely to be a fixed factor over the next two months.

4.

False. There is one exception to the price = marginal cost rule. The firm should not produce anything when the market price is so low that even if price equals marginal cost, the total revenue from producing the good is less than variable cost. In this case, the loss from closing down will equal the firm‘s fixed cost, which is a smaller loss than they would incur from producing the good.

5.

Not enough seeds for the plants needed to feed 6 billion people would fit in a single flowerpot, let alone develop into healthy plants with only a minuscule amount of soil available per seed.

6.

In general, the more readily a firm can acquire additional inputs, the more easily it can increase production in response price increases. Since it often takes time for firms to build new factories, install additional machinery and hire new workers, the elasticity of supply will typically be higher in the long run than in the short run.

Answers to Problems 1. a. If the price of a fossil is less than $6, Zoe should devote all her time to photography because when the price is, say, $5 per fossil, an hour spent looking for fossils will give her 5($5) = $25, or $2 less than she‘d earn doing photography. If the price of fossils is 6, Zoe should spend one hour searching, will supply 5 fossils, and will get $30 in revenue, 13 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

which is $3 more than she would earn from photography. However, an additional hour would yield only 4 additional fossils or $24 additional revenue, so she should not spend any further time looking for fossils. If the price of fossils rises to $7, however, the additional hour gathering fossils would yield an additional $28, so gathering fossils during that hour would then be the best choice, and Zoe would therefore supply 9 fossils per day. Using this reasoning, we can derive a price-quantity supplied relationship for fossils as follows: Additional Hours Total fossils number of per day per day fossils found 1 5 5 2 9 4 3 12 3 4 14 2 5 15 1

Lowest price per fossil $27/5 = $5.40, or $6.00 $27/4 = $6.75, or $7.00 $27/3 = $9.00 $27/2 = $13.50, or $14.00 $27/1 = $27.00

b. When we plot the points from the table we derived in (a), we get Zoe‘s daily supply curve for fossils: Price ($/fossil) 27

14 9 7 6 5

9 12 15 14

Number of fossils

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2. The market supply curve (right) is the horizontal summation of the supply curves of the individual market participants (left and center).

P

P

P=2Q1

P=2+Q 2

P

6

6

4

4

4

2

2

2

1

2

3

Q1

2

4

S

6

Q2

1

4

7

Q

Horizontal summation means holding price fixed and adding the corresponding quantities.

Thus, at a price of $2 we add the associated values of quantity supplied for S 1 (1.0) and S2 (0.0) to get the associated industry quantity supplied of 1.0. Repeating for price levels of $0, $4, and $6 generates our graphical solution.

For those who prefer a more algebraic solution, you can derive the market supply curve algebraically by solving each individual supply curve for quantity and adding together the quantities.

That is, the first step is to do the following: for P = 2Q1, divide by 2 to get Q1= P/2 and for P = 2 + Q2, subtract 2 from both sides to get Q2 = P – 2.

The second step is to add together the quantities; however, pay careful attention to the region for which the supply curves don't overlap (here, the region P < 2). For the region P < 2, the market supply is the same as firm 1's supply Q = P/2 or P = 2Q. For P > 2, we add Q1 + Q2 to get Q = P 2 (P 2), which reduces to Q = (3P 2) 2. Rewriting this in terms of P, we have P = (4/3) + (2/3)Q for P > 2. Expressed algebraically, the market supply curve is thus P = 2Q for P < 2 and P = (4/3) + (2/3)Q for P > 2.

3. The marginal cost of each of the first 6 air conditioners produced each day is less than $120, but the marginal cost of the 7th air conditioner is $140. Therefore, the company should produce 6 air conditioners per day.

Air conditioners per day 1 2 3 4

Total cost ($ per day) 100 150 220 310

Marginal cost ($ per day) 100 50 70 90

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5 6 7 8

405 510 650 800

95 105 140 150

4. a. As indicated by the entries in the next-to-last column of the table below, the profitmaximizing quantity of bats for Paducah is 20 per day, which yields a daily profit of $35.

The same result is also obtained by using the price-maximization rule: Price = Marginal cost. The last column shows the marginal cost at each output level. At 20 bats per day the marginal cost is $9, which is less than the price of $10, but if Paducah increases production to 25 bats per day the marginal cost rises to $12. Thus, the profit-maximizing quantity is 20 bats per day Q Number of Total revenue (bats/day) Employee Hours ($ per day) per day 0 0 0 5 1 50 10 2 100 15 4 150 20 7 200 25 11 250 30 16 300 35 22 350

Total labor cost ($ per day)

Total cost ($ per day)

Profit ($ per day)

0 15 30 60 105 165 240 330

60 75 90 120 165 225 300 390

–60 –25 10 30 35 25 0 –40

Marginal cost per bat ($ per day) — 3 3 6 9 12 15 18

b. A tax of $10 per day would decrease Paducah‘s profit by $10 per day at every level of output. But the company would still maximize its profit by producing 20 bats per day. A tax that is independent of output does not change marginal cost, and hence does not change the profit-maximizing level of output. c. A tax of $2 per bat has exactly the same effect as any other $2 increase in the marginal cost of making each bat. That is, the marginal cost of producing the 15th bat is $8, but as soon as Paducah produces 5 more bats its marginal cost rises to $11, which is higher than the price of $10 per bat. Similarly, the next-to-last column of the table below shows that the company‘s profit-maximizing level of output falls to 15 bats per day since that is the only output level without a negative profit (loss).

Q (bats/day) 0 5 10

Number of Total revenue Total labor Employee ($ per day) cost($ per day) Hours per day 0 0 0 1 50 15 2 100 30

Total cost ($ per day)

Profit ($ per day)

Marginal cost ($ per day)

60 85 110

–60 –35 –10

— 5 5

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15 20 25 30 35

4 7 11 16 22

150 200 250 300 350

60 105 165 240 330

150 205 275 360 460

0 –5 –25 –60 –110

d. If the government imposes a tax of $10 per day on the company, then the company will have to pay the same amount each day regardless of how many bats it produces. In other words, the tax will increase the company‘s fixed cost, and as a result, it will not affect the company‘s profit-maximizing level of output. On the other hand, if the government imposes a tax of $2 per bat, then the marginal cost of producing each bat will increase, and as a result, the profit-maximizing number of bats will fall. Note that both taxes lower the firm‘s profit

5. a. The supply curve would not shift. The tax on soda sweetened with high-fructose corn syrup will reduce the demand for corn, thereby lowering the price farmers receive for their corn making. As a result, farmers will reduce the quantity of corn supplied (a movement along the supply curve). b. The supply curve would shift to the left. Higher opportunity cost for farmers means that the cost of production is higher, reducing the number of farmers producing corn. c. The supply curve would not shift. The discovery is likely to increase the demand for corn, which will bring up the price of corn and thereby increase the quantity of corn supplied (a movement along the supply curve).

6. Because it takes time for producers to switch from one activity to another, the price elasticity of supply will be higher for most goods in the long run than in the short run.

7. The expression for supply elasticity is

P 1 .  Q slope

Using the information in the graph, the slope of the graph can be obtained by dividing the vertical difference between A and B ($2) with the horizontal difference (3 units). The slope of the supply curve is then 2/3.

The elasticity of supply at point A is

4 1 4 3 2     , or 0.67 9 2 9 2 3   3 17 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

8 11 14 17 20

Similarly, the elasticity of supply at point B is

6 1 1 3 3     , or 0.75 12  2  2 2 4   3

CHAPTER 5 EFFICIENCY, EXCHANGE, AND THE INVISIBLE HAND IN ACTION Answers to Review Questions 1. The owner of a business typically supplies valuable resources to the firm. There are always alternative uses of these resources, and it may be the case that he can earn a high rate of return on these resources in one of these alternative uses. If this is the case, then the implicit cost of these resources will be large and will drive economic profit to zero.

2. Wages have risen steadily over the past decades, largely because of productivity increases in manufacturing. Thus the cost of repairing a radio is now higher than the price of a new one, since the cost of having a radio repaired is mostly determined by the earnings of the people doing the repairs.

3. Market forces, such as entry to and exit from an industry, shift supply curves and cause price changes that eliminate economic profit. There are no similar processes that affect the economic rent, since economic rent is the return to factors of production that are not easily duplicated.

4. If a policy is not efficient, then it can, by definition, be altered in a way that benefits at least some people without harming others. Economists therefore favor efficient policies because such policies make additional resources available for the pursuit of other goals.

5. If enacted, the proposed policy will not, by itself, make everyone better off. However, suppose the policy is combined with a tax on workers that is used to pay for a $5 million per year increase in Social Security payments for retirees. This combination will make everyone better off since economic surplus for retirees will rise by $4 million ($5 million in increased Social Security payments minus $1 millions of lost surplus from enacting the new policy) 18 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

and for workers by $94 million ($100 million in increased surplus minus $5 million in taxes to pay for the increased Social Security payments.)

Answers to Problems 1. a. False. The maxim tells us that there are no unexploited economic opportunities when the market is in long-run equilibrium. In fact, there often are unexploited economic opportunities in the short run when markets are not in equilibrium. b. False. Firms in long-run equilibrium make zero economic profits. They make a positive accounting profit since, in order to stay in business, the firm must earn enough revenue to cover both explicit costs and implicit costs. Thus, accounting profit, which is equal to total revenue minus explicit costs, must equal the opportunity cost of the owner‘s resources that have been invested in the firm. c. True. Firms that introduce cost-saving innovations can earn economic profits until other firms adopt their innovations. As the innovations spread, the industry supply curve will shift right, causing the market price of the good to fall and short-term economic profits to fall.

2. a. Jaime‘s accounting profit is her revenue minus her explicit costs: $5,000 – $4,250 = $750 b. In this case, Jaime‘s opportunity cost to run the café is $725 per year ($1,000 – $275 = $725). Thus, the café is making an economic profit of $25 per year ($5,000 – $4,250 – $725 = $25). Since the café is earning an economic profit, Jaime should stay in the café business. c. In this case, Jaime's opportunity cost of running the café is $825 per year ($1,100 – $275 = $825). Thus, the café is earning an economic loss of $75 per year ($5,000 – $4,250 – $825 = -$75). Since the café is earning an economic loss, Jaime should not stay in the café business. d. Jaime‘s accounting profit equals her revenue minus her explicit costs. The answer to part a changes. If she doesn‘t need a loan, then her explicit costs equal $3,250. So, her accounting profit equals $1,750 ($5,000 – $3,250 = $1,750).

The answer to part b does not change. If Jaime invested $10,000 of her own money in the café, she could have earned $1,000 per year in interest by putting the money in a savings account. That amount is an opportunity cost that must be included when calculating economic profit. Thus, the reduction in explicit costs, by not taking out the loan, is offset by the increase in implicit costs of investing her money in the café. Jaime‘s economic profit is therefore unaffected. e. To earn a normal profit, the café would have to cover all its implicit and explicit

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costs. The opportunity cost of Jaime's time is $1,000 per year while the café's accounting profit is only $750 per year. Thus, the café would have to earn additional revenues of $250 per year in order for Jaime to make a normal profit.

3. Without a patent, there is nothing stopping the innovation from spreading across the industry to other firms. As knowledge of the innovation spreads, more firms will make profits, and those profits will catch the attention of more and more outside investors, who will desire to enter the industry. As they enter the industry, the supply curve will shift to the right, which will reduce the price and eventually eliminate the profits generated by the innovation.

4. a. The company that employs Janus will collect $500,000 more in revenue than the other advertising companies in New Orleans. Thus, Janus will earn $600,000 per year: the normal salary for a designer ($100,000) plus the additional revenue Janus generates for the firm that hires her ($500,000). Since Janus‘s economic rent is $500,000 per year, 5/6 of her salary (roughly 83 percent) is economic rent. b. If the company that employs Janus tries to pay her the salary of a normal designer, the owners of other companies will have an incentive to offer Janus a higher salary to bid her away because she generates $500,000 per year in additional revenue for whichever company hires her. In fact, Janus's salary will be bid up until no economic profit remains, which occurs when she earns $600,000 per year

5. a. The short-run economic profit for a cotton farmer is: Economic profit = Total Revenue – Explicit costs – Implicit costs Economic profit = $60,000 – $14,000 – $6,000 Economic profit = $40,000 In the long run, more factory workers would want to move into cotton farming, and would thereby bid up the rent on cotton farms. The rent would continue to rise until it reached $50,000 per farm. At that point the incentive to leave a factory job would no longer exist since cotton farmers would again be making zero economic profit. b. Landowners would reap the long-term benefits of the scheme. Their income would rise by $40,000 per year per 120-acre plot because rent would rise from $10,000 to $50,000.

6. The restaurant that employs the unusually talented chef will collect $500 more in revenue each week than the other restaurants in Wells. Thus, the unusually talented chef will earn $700 per week: the usual market price for a chef ($200 per week) plus the additional revenue the chef generates for the restaurant that hires him ($500 per week).

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7. a. Lowering the rate that older adults are charged for electricity is equivalent to lowering the price of electricity, leading to an increase in the quantity demanded. b. Since normal rates mirror the cost of providing power, if rates are cut in half, the price of electricity will be below the cost of producing it. As a result, older adults will use electricity wastefully and total economic surplus will fall.

8. Since the normal rates mirror the cost of providing power, any policy that changes the price of each kilowatt-hour of power will lower total economic surplus. A more efficient policy would be for regulators to give older adults either a tax break or an income subsidy to help them pay their electric bill. As long as neither the tax break nor the income subsidy depended on the amount of electricity consumed, neither would change in the price of each kilowatt-hour.

CHAPTER 6 MONOPOLY, OLIGOPOLY, AND MONOPOLISTIC COMPETITION Answers to Review Questions 1. The pure monopolist, the oligopolist, and the monopolistically competitive firm all face downward-sloping demand curves.

2. False. A firm with market power is one that faces a downward-sloping demand curve for its product. This implies that a firm can choose its price, but then the quantity it sells is determined by the demand curve. Similarly, a firm can choose the quantity it wants to produce and sell, but the demand curve then shows the price at which the firm can sell its product.

3. Without patent or copyright protection, firms would have little incentive to incur the costs needed to develop new products. The gains from encouraging new product development generally outweigh the inefficiency of higher prices.

4. In order to sell more units of a good, a monopolist must cut the price on all units in order to expand sales. This means that the additional revenue received from an additional unit sold, the price, is offset by the diminishing revenue from the current number of units sold. A perfectly competitive firm can, by contrast, sell any number of additional units at the (constant) market price.

5. False. The natural monopolist, like any other monopolist, sets price above marginal cost.

However, for the natural monopolist, marginal cost is always less than average cost, so the 21 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

average cost may exceed price at the profit-maximizing level of output. Thus, it is not necessarily the case that a natural monopolist earns a positive economic profit.

Answers to Problems 1. a. False. The industry demand curve is downward sloping in both cases, but from the individual perfectly competitive firm‘s point-of-view, the demand curve is horizontal.

Because the individual firm is too small to affect the market price, it can sell as many units as it wishes at that price. b. True. Perfectly competitive firms are price takers (i.e., if they try to charge a higher price, they will lose all their business). Similarly, there is no reason to charge a lower price as they can sell any quantity they choose to at the current price. c. True. This is the essential feature of a natural monopoly.

2. As shown in the following table, Honda‘s greater production volume gives it substantially lower average production cost. This advantage helps explain why Honda‘s market share has, in fact, been growing relative to Nissan‘s.

Annual production Fixed cost Variable cost Total cost Average cost per car

Nissan 50,000 $1,000,000,000 $500,000,000 $1,500,000,000 $30,000

Honda 200,000 $1,000,000,000 $2,000,000,000 $3,000,000,000 $15,000

3. The monopolist chooses the output level at which marginal revenue equals marginal cost and then charges a price consistent with demand at that level of output. Since price is greater than marginal revenue for a monopolist, price is also greater than marginal cost.

The quantity produced by the monopolist at the monopoly price is exactly equal to the quantity demanded by consumers, so the monopolist does not cause excess demand or shortages (even though the monopolist‘s profit-maximizing level of output falls below the socially efficient level). And the monopolist has no reason to maximize marginal revenue (which would require producing zero units of output).

4. The answer is a. The demand curve and the marginal revenue curve would coincide, because if a monopolist could perfectly discriminate, it would sell each successive unit of output for exactly its reservation price, so the marginal revenue generated from selling each successive unit would equal its reservation price. The final unit of output would be sold at a price equal 22 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

to marginal cost, so e is wrong: the outcome would be socially efficient. Because two or more consumers might have the same reservation price, c is wrong.

5. If a firm wishes to price discriminate, it needs to be able to identify and separate consumers that are willing to pay more from consumers that have a lower willingness to pay. This is a profit-increasing strategy for the firm. Often, in order to separate customers, some minor differences are incorporated into the product that will appeal to customers with a higher willingness to pay, and then a higher price is charged for this slightly different product.

For example, a well-known mail-order firm sells down-filled comforters with a plain stitch pattern at a lower price than slightly warmer comforters with a fancier stitch pattern. The price differential is about 100 percent.

6. a. George‘s total and marginal revenue: Customer

Reservation price ($/photo)

Total revenue ($/day)

1

50

50

Marginal revenue ($/photo) 50 42

2

46

92 34

3

42

126

4

38

152

5

34

170

6

30

180

7

26

182

8

22

176

26 18 10 2 -6

George should continue to serve additional customers as long as his marginal revenue at least covers his marginal cost of $12. Thus, George will set a price consistent with serving only the first five customers. That price is the reservation price of the fifth customer, $34. His profit will equal his total revenue minus his total cost, or ($34 × 5) – ($12 × 5) = $170 – $60, or $110 per day. b. Consumer surplus = ($50 – $34) + ($46 – $34) + ($42 – $34) + ($38 – $34) + ($34 – $34) = $40 per day.

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c. The socially efficient number of portraits is 8, since each customer has a reservation price that exceeds the marginal cost of production. d. George will produce 8 portraits, and his economic profit will be ($50 + $46 + $42 + $38 + $34 + $30 + $26 + $22) – ($12 × 8), or $192 per day. e. No consumer surplus will be generated since each customer is paying a price equal to his/her reservation price.

7. a. The ability to offer a rebate coupon allows George to divide his market into two submarkets. The table of total and marginal revenue for the list price submarket is as follows:

Customer

Reservation price ($/photo)

Total revenue ($)

1

50

50

Marginal revenue ($/photo) 50 42

2

46

92 34

3

42

126 26

4

38

152

5

34

170

18

George should set the price at $34 and sell 5 photos per day in this market, since for each of these 5 customers marginal revenue is greater than or equal to marginal cost. In the discount-price submarket, the table of total and marginal revenue is as follows: Customer

Reservation price ($/photo)

Total revenue ($/day)

6

30

30

Marginal revenue ($/photo) 30 22

7

26

52 14

8

22

66

The discount price should be $22 and George should sell 3 photos in this market, since for each of these 3 customers (customer number 6, 7, and 8) marginal revenue is greater than or equal to marginal cost. b. George‘s economic profit is now ($34 × 5) + ($22 × 3) – ($12 × 8), or $140. Consumer 24 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

surplus is ($50 – $34) + ($46 – $34) + ($42 – $34) + ($38 – $34) + ($34 – $34) + ($30 – $22) + ($26 – $22) + ($22 – $22), or $52.

8. a. See 3rd and 4th rows of the table below.

Price Quantity Total Revenue Marginal Revenue

$1 1 $1

$0.90 2 $1.80

$0.80 3 $2.40

$0.70 4 $2.80

$0.60 5 $3.00

$0.50 6 $3.00

$0.40 7 $2.80

$0.30 8 $2.40

$0.20 9 $1.80

$0.10 10 $1

$1

$0.80

$0.60

$0.40

$0.20

$0

$-0.20

$-0.40

$-0.60

$-0.80

b. Jada will maximize profits where Marginal Revenue = Marginal Cost. This occurs at a price of $0.60. The corresponding quantity sold is 5 glasses of lemonade. c. Profit equals total revenue minus total cost. Since Jada has no fixed costs, at a price of $0.60 her profit equals (5 × $0.60) – (5 × 0.20) = $2 per day.

Total consumer surplus in Jada‘s lemonade market is found by adding together the price each consumer is willing to pay minus the price they actually pay.

Total consumer surplus = ($1 – $0.60) + ($0.90 – $0.60) + ($0.80 – $0.60) + ($0.70 – $0.60) = $1 per day. d. Total economic surplus is maximized where the price charged is equal to marginal costs.

In this market, marginal cost is constant at $0.20 per cup. e. She would charge persons A through I their respective reservation prices. Doing so would earn her a profit of $3.60, which is the same as the total economic surplus in part d. Note that the total economic surplus is maximized in both this problem and part d, but the distribution of the surplus is different.

CHAPTER 7 GAMES AND STRATEGIC BEHAVIOR

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Answers to Review Questions 1. A game has three basic elements: the players, the list of possible actions (or strategies) available to each player, and the payoffs the players receive for each possible combination of strategies.

2. If you were going to play the prisoner‘s dilemma game indefinitely many times with the same partner, you and your partner have a strong incentive to cooperate, because you each know that you can punish the other for defecting.

3. Each contestant in a military arms race faces a choice between maintaining the current level of spending on weaponry or spending more on weapons. Further, each side views military superiority as the best possible outcome and each side views military inferiority as the worst possible outcome. The other two possible combinations are for both sides to maintain their current spending or for both sides to spend. Each nation would prefer the former, since both result in military parity. Assuming the contestants are the USA and the former USSR, these rankings give rise to the following payoff matrix. Each side‘s dominant strategy is to spend more on weapons, yet the result when each side spends more is less attractive than if each side had held spending at current levels.

Spend the same on weapons Spend the same on weapons

Second best for each

USSR

Spend more on weapons

Best for USSR Worst for USA

USA Spend more on weapons

Best for USA Worst for USSR

Third best for each

4. By waiting, Warner Brothers put itself in the position of having to reshoot many scenes if they used a singer other than Tony Bennett. Warner Brothers would have done better to negotiate with Bennett before filming, when the reservation price for his services would have been much lower (because at that point, the film could more easily have been adapted).

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5. Once the firm buys the specialized capital equipment, it becomes a sunk cost since it cannot be used to serve any buyer besides GM. With no prior agreement about the price of the door handles, GM would then be in a position to offer a price greater than the marginal cost of making the door handles, but too low to enable the firm to recover its capital costs. At that point, GM knows that the firm would be better off accepting the offer than refusing it. To guard against this possibility, the firm will want to sign a long-term contract specifying the price of the door handles before it invests in specialized capital equipment.

6. Because the waiter in this situation knows that a selfish diner would have no incentive to tip at the end of the meal, he would not bother providing good service, even though his cost of providing good service is less than the diner would be willing to pay for it. That most diners do in fact leave tips in restaurants located on interstate highways suggests that people are not always selfish in the narrowest sense of the term.

Answers to Problems 1. a. The payoff matrix should look like the one below:

b. No, neither player has a dominant strategy. Recall that a dominant strategy is one that yields a higher payoff regardless of the strategy chosen by the other player. In this game, if your friend chooses Heads, then your payoff is higher when you choose Heads. On the other hand, if your friend chooses Tails, then your payoff is higher when you choose Tails. Since your best course of action varies depending on what your friend does, you do not have a dominant strategy. Similarly, if you choose Heads, then your friend is better off choosing Tails, and if you choose Tails, then your friend is better off choosing Heads.

Thus, your friend also does not have a dominant strategy. c. No, there is no equilibrium. As discussed in part b, you will always be better off when you chose the same side as your friend; however, if both sides match, then your friend will be better off choosing a different side, but if your friend changes sides, then you too will want to change sides.

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2. The decision tree should look like the one below:

At point B on the decision tree, Sally‘s payoff will be higher if she accepts, no matter what K is. So her best choice is to accept. Knowing this, Harry gets the highest payoff by choosing K = 1. Sally‘s payoff will be $0.25, and Harry‘s will be $0.75.

3. Blackadder knows that both his and Baldrick‘s dominant strategy is to confess, so this information is worth nothing to Blackadder.

4. a. The strategies, players and payoffs are shown in the following payoff matrix:

Benefits: Good grade: 20 Average grade: 5 Poor grade: 0 Costs: Study a lot: 10 Study a little: 6 In the upper-left corner and the lower-right corner, you and the other students are doing the same thing (either all studying a lot – upper-left or all studying a little – lower-right).

In this case they will all receive an average grade and a benefit of 5. The costs of studying a lot are 10 so the payoffs in the upper-left corner are a benefit of 5 less a cost of 10 or ‗-5‘. The costs of studying a little are 6 so the payoffs in the lower-right corner are a benefit of 5 minus a cost of 6 or ‗-1‘.

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In the lower-left, you study a little and all other students study a lot. For you, the benefits with the poor grade are ‗0‘ with costs of 6 and a payoff of ‗-6‘. For the other students who are studying a lot, the benefit of a good grade are 20 less the cost of studying a lot of 10 resulting in a payoff of ‗10‘.

The outcomes in the upper-right are just the opposite. You study a lot, gets a good grade with a payoff of ‗10‘. Other students study a little, get a poor grade with a payoff of ‗-6‘. b. The equilibrium outcome for this game is for you and the other students to study a lot and receive an average grade. Both the other students and you would be better off if everyone studying a little because it would have led to the same grade, but at a lower cost.

5. a. The strategies, players and payoffs are shown in the following payoff matrix:

Keep quota Company A Break quota

Company B Keep quota A regrets its decision B regrets its decision A does not regret its decision B regrets its decision

Break quota A regrets its decision B does not regret its decision A does not regret its decision B does not regret its decision

Starting in the upper-left cell, if both companies keep the quota, then fish stocks are large, and each company regrets not having broken the quota, because they could have earned higher profits by doing so. In the lower-right cell, both companies break the quota, and neither regrets it, because keeping the quota while the other company breaks it would lead to low profits. In the off-diagonal cells, one company earns higher profits from overfishing (which it does not regret), but the other suffers lower profits. Each company‘s dominant strategy is thus to break the quota, which means that both will do so unless some way can be found to enforce the quota. b. If Firm A pollutes from its factory and no one else does, then it gains from not having to install pollution-control equipment (which leads to lower costs and higher profits), as well as from clean air, since my own pollution has only a negligible effect on air quality. However, if all other industrialists think this way, the air will become polluted, and all firms will be worse off than if none had polluted. Profits may also be lower if all firms pollute because the cost advantage of polluting will be shared by all firms, and competitive forces (entry) will reduce prices and profits. c. In many potential prisoner‘s dilemmas, a way out of the dilemma for a would-be cooperator is to make reliable character judgments about the trustworthiness of potential partners, but in situations involving environmental degradation, the players usually do not know each other and there is thus no opportunity to make character judgments. In such cases, legal enforcement is often necessary.

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6. a. The two possible equilibrium outcomes are: i. Boeing produces and Airbus does not; ii. Airbus produces and Boeing does not.

If the manufacturers find themselves in one of these two cells, neither will want to change its strategy. For example, consider the case in which Boeing produces and Airbus does not. Given that Airbus does not produce, if Boeing changes its strategy to "Don't Produce", its payoff will fall from $100 million to $0. Similarly, given that Boeing produces, if Airbus changes its strategy to "Produce", its payoff will fall from $0 to -$5 million. Thus, each company is making the best choice given the other company's choice. A similar argument can be made about the case in which Airbus produces and Boeing does not. b. Revised payoff matrix that includes subsidy to Airbus:

Because of the subsidy, producing is now a dominant strategy for Airbus. And, since Boeing knows that Airbus will produce, Boeing‘s best choice is not to produce. c. In the absence of the subsidy, neither Boeing nor Airbus has a dominant strategy, and there are two possible equilibrium outcomes. One in which Boeing is the only manufacturer, and the other in which Airbus is the only manufacturer. The subsidy changes the game because it makes entering the market a dominant strategy for Airbus.

Knowing this, Boeing will not enter the market, and Airbus will be the sole manufacturer.

7. a. In this situation, each player’s payoffs are independent of the action taken by the other.

Each pail of water sells for $5, and since the cost of carrying each pail is less than $5, Jack and Jill will each carry 2 pails of water. b. When the two children are forced to share revenues, their payoff matrix is as follows:

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This game is a prisoners‘ dilemma. The dominant strategy for both Jill and Jack is to carry only one pail down the hill, even though each would be better off if both carried two pails. Therefore, their parents‘ plan creates an equilibrium with total payoffs of $6 rather than $10!

8. a. The owner knows that if he opens the remote office (top branch at A), the potential manager‘s best strategy is to be dishonest (bottom branch at B), in which case the owner earns a loss of $600. Since the owner loses money by opening the remote office, he will decide against opening the new office.

b. In this case, the owner knows that if he opens the remote office, the potential manager‘s best strategy is to be honest since $3,100 – $15,000 = -$11,900. Thus, the owner will open the remote office.

9. a. No, neither player has a dominant strategy since the best choice for each player depends on what the other player does. b. The top-left and bottom-right cells are both potential equilibria, since in each of these cells neither player has any incentive to change strategies.

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c. No, the payoffs in this game do not follow the pattern associated with a prisoner‘s dilemma because neither player has a dominant strategy. d. Player A knows that if he or she has the first move and buys a movie ticket, so will player B, in which case player A will get a payoff of 2. If player A buys a baseball ticket, so will player B, in which case player A will get a payoff of 3. Player A will therefore buy a baseball ticket, and so will player B. e. The reasoning is the same as for part d, except this time both players will see a movie.

10. a. Decision tree for this problem:

b. Since your payoff is -$30 if you protest and $0 of you defer, it is in your best interest to defer. Anticipating this, the other driver will steal your spot since his payoff is $10 of he steals your spot and $0 if he leaves the spot for you. So, the equilibrium outcome is $0 for you and $10 for the other driver. c. Suppose the other driver in addition to knowing your willingness to pay $30 to avoid a dispute, also believed that you would experience a psychological cost of say $25 if you failed to protest his unjust behavior. In that case, your payoff from deferring would be $25, making this the worst outcome for you. The other driver would then know that attempting to steal the spot at A would make you protest at B, thereby giving him a payoff of -$30. Therefore, the other driver would be better off leaving the spot for you, and the equilibrium outcome would be $10 for you and $0 for the other driver.

CHAPTER 8

INTRODUCTION TO BEHAVIORAL ECONOMICS

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7. The representative heuristic states that people tend to estimate the likelihood that a thing belongs to a given category by looking at the extent to which that thing resembles the stereotypical member of the category. Since the stereotype of a librarian is a shy person and the stereotype of a salesperson is a gregarious person, people are inclined to guess that any given shy person is more likely to be a librarian than a salesperson. But because there are so many more salespersons than librarians in the population, the absolute number of shy salespersons is actually considerably larger than the absolute number of shy librarians. The implication is that a randomly chosen shy person is more likely to be a salesperson than a librarian.

8. Costs and benefits of activities are measured in absolute dollar amounts. So when deciding, for example, whether driving across town to get a lower price on an object would be worth your while, you should compare that cost to the absolute dollar value of your savings, not to the percentage reduction in the purchase price.

9. Weight-loss camps restrict the amount of food available to attendees. People who enroll in these camps find them attractive because they want to lose weight, but perhaps believe they lack the willpower to restrict their food intake on their own.

10. Although the Affordable Care Act was unpopular before it was enacted into law, its passage reduced the number of uninsured people by many millions. Loss aversion suggests that once people have a thing—in this case, health insurance—they are reluctant to part with it. And hence the difficulty of repealing the ACA.

5. Context shapes almost every evaluation. For example, if the temperature is 60°F and we ask whether it‘s cold, people answer differently on a November evening in Miami than on a March afternoon in Montreal. A positional good is one whose evaluation is particularly sensitive to how it compares to other goods in the same category. iPhones are positional, because how people evaluate them depend on how their features compare with those of other phones in popular use.

6. Bidding wars for houses in better school districts are an important example of a collective action problem: Even when people draw down their savings entirely and borrow as much as lenders will permit, these bidding wars do little more than raise the price of houses in better school districts. Tax-financed retirement pensions are one attempt to mitigate this problem.

Overtime regulations and safety regulations may also be views as attempts to address this collective action problem.

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11. For every hundred trucks the witness sees, 20 are operated by United, the remaining 80 by North American. Since the witness is 90 percent accurate in her assessments of truck ownership, she will correctly identify 0.9 × 20 = 18 as operated by United, and incorrectly identify 0.1 × 80 = 8 as operated by United. So, 18 of every 26 vans she identifies as United will actually be operated by United. The probability of her being correct is thus 18/26, or 69 percent.

12. If she is serving better than usual, her next serves are more likely to revert to her average success rate, so regression to the mean (b) is correct. Double-faulting immediately after saying that you haven‘t double-faulted is a more memorable event than serving successfully immediately after saying that you haven‘t double faulted, so the availability heuristic (c) is also correct.

13. Under the reasonable assumption that police patrols are likely to increase in periods following crime increases, a subsequent decline in crime rates would be expected on the basis of regression to the mean alone.

14. For every hundred suspects Dalgliesh examines, 60 are liars, the remaining 40 truthful. Since Dalgliesh‘s assessments are 80 percent accurate, he will correctly identify 0.8 × 60 = 48 as liars, and incorrectly identify 0.2 × 40 = 8 as liars, which means that 48 of every 56 suspects he identifies as liars will actually be liars. The probability of his being correct is thus 48/56, or roughly 86 percent.

15. Under the reasonable assumption that most chefs have better nights and worse nights, the superb meals that Shobhana encounters will be more likely to come from chefs‘ better nights.

So, the fact that her second meal at a restaurant she revisits is not as good as the first would be expected solely on the basis of regression to the mean.

16. Rationality requires taking those actions whose benefits exceed their costs. Maria‘s benefit from driving across town to buy the blouse is the $16 (= 0.40 × $40) she will save, and, likewise, her benefit from driving across town to buy the stereo is $100 (= 0.10 × $1,000).

Since the cost of driving across town must be the same in both cases, if it is her interest to drive across town to purchase the blouse, then she should also make the trip to buy the stereo.

Conclusion: Her failure to do so implies that she is irrational.

17. If Tom is rational, then his decision to drive across town to save $10 on the clock radio implies that his opportunity cost of driving across town must be less than or equal to $10 (a), and that he should drive across town to make a purchase whenever he saves at least $10 (b).

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18. If Marco is rational, adding the racquet at C would be irrelevant, since it is worse on both dimensions then the one at B. But evidence suggests that adding C makes it more likely that people will choose B and less likely to choose A. The fact that people find it easy to see that B is better than C apparently boost their positive feelings about B.

19. If Crusoe is like many others, he may find it difficult to postpone current consumption in order to enjoy better opportunities in the future. Putting his coconuts in the cave eliminates the temptation to consume them right away.

20. Traditional economic models assume that the amount people would be willing to pay to acquire a mug should be equal, on average, to the amount for which they would be willing to sell a mug that they own, which implies that half the mugs would change hands. But behavioral evidence suggests that people‘s willingness to pay for things they don‘t own is substantially smaller than their willingness to accept for things already in their possession, which implies that less than half would change hands.

21. When the ability to achieve important goals depends on relative spending, individually rational spending decisions can produce spending patterns that make it difficult to save for retirement. Consider a family‘s goal of sending its children to the best possible schools. Because better schools tend to be located in neighborhoods with more expensive houses, a natural way for a family to pursue this goal is by saving less for retirement and spending more on housing. But when all families follow that strategy, they succeed only in bidding up housing prices. Families are left with lower retirement savings, yet all children still end up attending the same schools as before. A tax-financed retirement savings program would help moderate this spending pattern.

CHAPTER 9

EXTERNALITIES AND PROPERTY RIGHTS

Answers to Review Questions 1. No. While activities that generate external costs tend to be pursued excessively, i.e., there is more of the activity than the socially optimal level, the optimal quantity of such an activity is not zero. The optimal amount is that for which the marginal benefit of the activity equals the marginal cost, both private and external. Therefore, outlawing activities that generate 35 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

external costs would thus move society from a situation in which those activities were pursued too extensively to one in which they were pursued too little.

2. Freeways suffer from excessive congestion because individual motorists have no incentive to take external costs into account when deciding whether to drive on the freeway. Specifically, when a motorist enters an already congested freeway the road becomes marginally more congested, and this increases the travel time of thousands of other motorists.

3. Applying the Cost-Benefit Principle to the case of freeway congestion, the socially optimal amount of freeway capacity is when the marginal cost of expanding freeway capacity exactly equals its marginal benefit (as measured by the value to motorists of reduced travel time). To reduce freeway congestion to zero would mean building a quantity of freeway for which the marginal benefit of extra capacity would be zero. But that solution cannot be socially optimal, because the marginal cost of additional freeway capacity is always positive.

4. Pollution in the Great Salt Lake is regulated by a single state government, while many different states and Canadian provinces border Lake Erie and thus have jurisdiction over pollution there. Thus, enacting legislation that curbs pollution is harder for Lake Erie where no one regulatory agency or government controls pollution levels.

5. If there is a social advantage to being relatively tall, then individuals who wear high-heeled shoes will do better than others who don‘t. But high-heeled shoes also entail costs, and when everyone wears them, the relative height distribution remains unchanged.

Answers to Problems 1. a. Vaccinations entail benefits to people other than those who are vaccinated because people who are vaccinated against infectious diseases are less likely to contract those diseases and pass them on to others. Private markets tend to provide less than the socially optimal quantity of goods that entail external benefits. b. Cigarettes entail costs to people other than those who smoke because second-hand smoke has been shown to be harmful to people's health. Private markets tend to provide more than the socially optimal quantity of goods than entail external costs. c. On one hand, antibiotics entail an external benefit because a person who takes an antibiotic will be less likely to pass his or her bacterial infection on to others. One the 36 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

other hand, antibiotics also entail an external cost because bacteria often develop resistance to antibiotics and become less effective as more people use them. Whether private markets provide more or less than the socially optimal quantity of antibiotics depends on whether you think their external costs outweigh their external benefits.

2. According to the Coase Theorem, if people can negotiate with one another at no cost, they can always arrive at efficient solutions to the problems caused by externalities. In this case, the most efficient outcome is for Jones to emit smoke, because the total daily surplus in that case will be $600, compared to only $580 when Jones does not emit smoke. Since Smith has the right to insist that Jones emit no smoke, Jones will have to compensate Smith for not exercising that right. For example, if Jones pays Smith $30, each will be $10 better off than if Smith had allowed Jones not to emit smoke.

3. a. Collectively, John and Karl stand to save $200 per month in rental payments by living together since their total rent is $900 when they share and $1,100 when they each rent their own apartment. The question is whether this benefit justifies their living together despite John's objectionable habit of leaving his dirty dishes in the sink. The lowest-cost accommodation to the dirty-dish problem is for John to leave his dirty dishes in the sink.

In this case, the maximum monthly rent Karl would be willing to pay to share an apartment with John is $550 – $175 = $375 per month. This amount would leave John with a remaining monthly rent bill of $525 (the $900 rent minus the $375 Karl is willing to pay), which generates a social surplus of $25 per month since John would have to pay $550 if he lived alone. If John splits this surplus evenly with Karl, John ends up paying $537.50 per month and Karl pays $362.50 per month. Both John and Karl will therefore be better off living together. b. Adding an additional $30 per month to the cost of the shared living arrangement makes the total cost of sharing $205 per month (the $175 Karl would be willing to pay to avoid John‘s dirty dishes plus the $30 John is willing to pay to avoid giving up privacy).

Because that amount exceeds the $200 per month that John and Karl save by living together, they should live separately.

4. a. Khatia will not install and maintain soundproofing. Khatia‘s monthly payoff without soundproofing is $50 more than with it, so her natural inclination is not to install soundproofing. Gwendolyn would have to pay Khatia at least $50 to induce Khatia to install soundproofing, but since soundproofing is worth only $40 per month to Gwendolyn, Gwendolyn will not be willing to pay Khatia $50 to install the soundproofing. Since the joint payoff is $230 without soundproofing and $220 with it, their choice to not install soundproofing is socially efficient. b. Khatia‘s options are to either install soundproofing at a monthly of $50 or pay Gwendolyn $40 per month to compensate her for the noise she makes while practicing.

Thus, Khatia will not install soundproofing. As noted in part a, this choice is socially efficient.

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c. Either way, the efficient outcome (no soundproofing) is reached. The difference is that when Khatia has the right to make as much noise as he wants, his monthly payoff is higher than when Gwendolyn has the legal right to peace and quiet. Similarly, Gwendolyn‘s monthly payoff is higher when she has the legal right to peace and quiet than when Khatia has the right to make as much noise as she wants.

5. a. Khatia will now install and maintain soundproofing, because doing so is cheaper than compensating Gwendolyn at a rate of $60 per month for the noise nuisance. This outcome is socially efficient. b. Khatia will not install soundproofing in this case. The noise costs Gwendolyn $60 per month, so in the absence of transaction costs Gwendolyn would be willing to pay up to that amount to induce Khatia to install soundproofing. However, if Gwendolyn must also pay a $15 fee for this transaction, it is not worthwhile. Thus, no soundproofing will be installed, and the outcome will be socially inefficient. c. If Gwendolyn has the legal right to peace, then installing and maintaining the soundproofing will be cheaper for Khatia than to pay Gwendolyn $60 per month compensation for noise damage. In this case, the outcome is socially efficient. d. When negotiation is costly, the Coase theorem does not guarantee that private parties will arrive at the socially efficient outcome. Thus, the attainment of the socially efficient outcome will depend on who has the legal right to perform the activity that generates the externality.

6. a. False. A variety of other tools are also employed. Some jurisdictions, for example, employ noise ordinances that prohibit loud music and other noises during certain hours.

Other jurisdictions have required power companies to burn low-sulfur coal to drive their generators. b. False. Since in the absences of policy measures to discourage activities that generate negative externalities, they would be undertaken at inefficiently high levels. Taxing such activities makes them less attractive, thus limiting damage imposed on others. c. True. Taxing such activities makes them less attractive, thus limiting damage imposed on others. d. False. In the absence of policy measures to encourage activities that generate positive externalities, such activities would be undertaken at inefficiently low levels. Taxing such activities makes them even less attractive, which makes the resulting efficiency losses even larger.

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7. The table below shows the total village income from grazing llamas as well as the marginal village income from the activity: Number of llamas on the commons

Price per 2year-old llama ($)

Income per llama ($/yr.)

Total village income ($/yr.)

1

122

22

22

2

118

18

36

3

116

16

48

4

114

14

56

5

112

12

60

Marginal village income ($/yr.)

22 14 12 8 4 -6

6

109

9

54

b. If each villager decides individually how to invest, then the villagers will continue to send llamas onto the commons as long as the income each earns from doing so is greater than $15, the amount a villager could earn from buying a government bond. Thus, from the information in the "Income per llama" column in the table above, we can see that 3 llamas will be sent onto the commons. The resulting net village income will be $48 from the llamas plus $45 from government bonds, or $93. c. A llama should be sent onto the commons if and only if its marginal contribution to total village income is greater than $15, the amount a villager could earn from buying a government bond. Thus, the socially optimal number of llamas on the commons is 1.

When the villagers decide individually how to invest, they send 3 llamas, rather than just 1, because in deciding whether or not to send a llama each villager ignores the negative impact of his or her llama‘s presence on the other llamas‘ fleece quality. Total village income with 1 llama on the commons is $22 from the llama plus $75 from government bonds, or $97 in total. d. If a single villager could control access to the commons, she would send only a single llama onto the commons (since the marginal income per year is less than $15 beyond the first llama), which she could sell after one year for $22 more than she paid for it. If the land were free, the owner would thus earn $22 per year by raising one llama per year on it, or $7 more than she would have earned had she used her $100 to buy a bond. The price of the land will be bid up until owning the land is no better than putting the same amount in the bank at 15 percent interest. That price is the amount of money, X, that would yield $7 per year if deposited at 15 percent interest: 0.15X = $7, or X = $46.67. The new owner will graze one llama. Total village income will be the same as in part b.

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8. a. Since each cyclist's payoff depends on his relative performance, any step either takes to improve his performance will necessarily lower the expected payoff of the other. b. See below. To see how the numbers in the table were calculated, note that, for example, when both Lance and Jan dope, each has a 50 percent chance of winning, so both Lance and Jan have an expected payoff of (0.50 × $100,000) − $25,000 = $25,000.

c. Note that this game is a prisoner's dilemma. For both Jan and Lance, doping is a dominant strategy. Yet when both dope, each gets an expected payoff of only $25,000. Each would have had an expected payoff of $50,000 if they both did not dope.

CHAPTER 10

USING ECONOMICS TO MAKE BETTER POLICY CHOICES

Answers to Review Questions 1. Individuals tend to ignore the fact that if they are infected with a disease, this will impose additional risks on others. Thus, if vaccinations are not a legal requirement for entry into public schools, the equilibrium rate of vaccination will be below the optimal rate.

2. Efficient resource use requires that the buyer pay a price equal to the marginal cost of the resource. First-dollar health care coverage is inefficient because it violates this principle.

Specifically, policyholders are reimbursed for all medical expenses and thus face an effective price of zero for medical care, while the marginal cost of medical services is clearly some positive amount. This leads policymakers to use more medical care than is optimal.

3. Efficient cleanup requires that the marginal cost of pollution reduction be the same for every polluter. If this is not the case, it is possible to reduce the total cost of pollution reduction by 40 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

having polluters with high marginal costs remove less and those with low marginal costs remove more. Pollution taxes and the sale of effluent permits result in marginal costs of pollution reductions that are the same for all polluters. Across-the-board-cutbacks, in contrast, result in marginal costs of pollution reduction that are higher for some firms than others and thus result in inefficient cleanup efforts.

4. A negative income tax grant that was big enough to maintain living standards of the poor would also be large enough to induce many people to leave the workforce and live at taxpayer expense. Such a program would therefore be politically unpopular as well as prohibitively expensive.

Answers to Problems 1. a. Since David will have to pay $150 per day for any hospital stay that costs less than $1,000 he will choose to stay in the hospital 2 days. b. With full coverage, the marginal cost to David of staying in the hospital is zero, so he will stay until the marginal benefit of staying in the hospital is zero, or 8 days. This choice fails the cost-benefit test because the marginal benefit of the 8th day in the hospital ($0) is less than its marginal cost ($150).

2. a. Dave would stay only one day since his willingness to pay for the second day ($200) is less than the cost of the second day ($250). b. If Dave‘s insurance covers half of the cost of each hospital day, he would pay $125 a day.

Thus, Dave would choose to stay two days since his willingness to pay for a third day ($100) is less than $125. c. Examples may vary. One possibility is if Dave‘s insurance stops covering hospital stays and instead reduces the cost of his health insurance by $225.

3. a. If pollution is unregulated, both firms will use process A and emit 8 tons per day. b. To reduce emissions by 50 percent, both firms must switch to process C. The cost will be $120 – $50 = $70 for Sludge Oil and $500 – $100 = $400 for Northwest Lumber, for a total cost of $470. c. Each firm will switch to a cleaner process if the cost of doing so is less than $T. If T = $81, Sludge Oil finds it worthwhile to switch from process A to B, and still finds it worthwhile to switch from process B to C, and again from C to D. Northwest Lumber finds it worthwhile to switch from process A to B. Sludge Oil thus cuts emissions by 3

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tons, and Northwest Lumber by 1 ton. The total cost to society is $200 – $50 + $180 – $100, or $230.

4. If Sludge Oil does not have any permits it will have to pay $500. Sludge Oil is therefore willing to pay up to $300 for the first permit, which is the cost difference between process E and process D. Sludge will pay up to $80 for the second permit, and so on.

If Northwest Lumber does not have any permits it will have to pay $2,000. Northwest Lumber is therefore willing to pay up to $1,000 for the first permit, which is the cost difference between process E and process D. Northwest will pay up to $500 for the second permit, up to $320 for the third, and up to $80 for the fourth.

Therefore, the auction price will keep rising until it reaches $81, the lowest price for which the total demand is 4 permits. Sludge Oil will buy 1 permit and Northwest Lumber will buy 3 permits. The total cost of the pollution reduction is $230. Sludge Oil now pays $200 instead of $50, and Northwest Lumber pays $180 instead of $100.

5. Countries maintain armies at great expense even when they are not certain that those armies will ever be called into action. If the consequences of being invaded are sufficiently grave, it can be rational to maintain an expensive army even if an invasion would never have occurred.

The same logic applies in the case of investments in reducing greenhouse gases. Inherent uncertainties in climate science mean that we cannot be sure what the payoff from those investments will be. But the fact that climate estimates are highly uncertain means that the worst consequences could be very grave indeed. To reduce the likelihood of such consequences, it can be rational to invest heavily in reducing greenhouse gases.

6. Without a minimum wage, employers and workers each receive an economic surplus of $50,000 per day. As shown in the diagram below, a minimum wage set at $12 per hour reduces employer surplus to the area of the cross-hatched triangle, $32,000 per day, and increases worker surplus to the area of the four-sided shaded figure, $64,000 per day. The minimum wage thus reduces employer surplus by $18,000 per day and increases worker surplus by $14,000 per day. Based on this information, employers would be willing to pay a tax up to $18,000 to enact the earned-income tax credit rather than the minimum wage. A tax of $16,000 levied on employers could therefore fund an earned-income tax credit of $1.60 per hour × 10,000 hours = $16,000, which is more than the $14,000 increase in worker surplus that the minimum wage would provide. Clearly, this arrangement would make both employers and workers better off than under the minimum wage.

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CHAPTER 11

INTERNATIONAL TRADE AND TRADE POLICY

Answers to Review Questions 1. An individual has a comparative advantage in the production of a particular good if she can produce it at a lower opportunity cost than other individuals. An individual has an absolute advantage in the production of a good if she can produce more of that good than another individual, using comparable amounts of time, raw materials and effort.

2. If the world price of coffee is twice the world price of tea, the economy will do best by producing only coffee, then trading for as much tea as domestic citizens want at the rate of two pounds of tea per pound of coffee. Likewise, if the price of coffee is half that of tea (i.e., the price of tea is twice that of coffee), the economy should produce only tea and trade for as much coffee as it needs. If the world price of coffee equals the world price of tea, then the opportunity cost of a pound of tea is the same whether it is produced domestically or acquired from abroad. So in this special case there is no benefit from trade and the country should just produce its own coffee and tea in the proportion that its citizens prefer.

3. False. Even if a country has an absolute advantage in every sector, there are likely to be sectors in which the neighboring country has a comparative advantage. If so, then both countries can benefit from trade.

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4. A reduction in trade barriers between the two countries would lead to an increase in exports from the industries in each country that enjoy a comparative advantage: more cheese would be shipped from France to England, more bicycles from England to France. British dairy farmers and French bicycle manufacturers would see demand for their products fall, giving these groups a strong incentive to block the trade expansion. On the other hand, if the adversely affected groups had sufficient political power, they would have an even better option: The fact trade expansion would make national income higher in both countries means that it would be possible to redistribute income in both countries so that all parties come out better off than before the expansion. This better outcome, however, could only be achieved if the two governments implemented the requisite compensation payments.

5. See the figure below. The tariff raises the domestic price of automobiles to the world price plus the tariff. Facing a higher domestic price for cars, domestic producers supply more cars and domestic consumers demand fewer cars. Imports, the difference between the domestic quantities demanded and supplied, decline. Consumers are hurt by the tariff, as they must pay more for cars, while domestic producers (who receive a higher price for their output) are helped. The government benefits by collecting tariff revenue. Overall, though, the tariff is inefficient; the costs to consumers exceed the benefits to producers and the government.

6. See the figure below. If the quota allows fewer imports than would occur under free trade, then the domestic price will be higher than the world price. Consumers face a higher price and are thus worse off; domestic producers, who receive a higher price for their output, are better off. Unlike the case of a tariff, with a quota the government collects no revenue; those revenues flow instead to holders of import licenses, who can buy cars at the world price and re-sell them at the higher domestic price.

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Answers to Problems 1. In the time it takes Ted to wash a car he can wax 3 cars (60 minutes/20 minutes per wax job).

Therefore, Ted‘s opportunity cost of washing one car is 3 wax jobs. In the time it takes Ishana to wash one car, 30 minutes, she can wax 2 cars (30 minutes/15 minutes per wax job).

Therefore, Ishana‘s opportunity cost of washing one car is 2 wax jobs.

Alternatively, you can compute how many cars each person can wash or wax in a certain time period, such as an hour, and then use these quantities to compute their respective opportunity costs. In 60 minutes, Ted can wax 3 cars or wash 1 car, so his opportunity cost of washing one car is 3 (= 3/1) wax jobs. Likewise, in 60 minutes, Ishana can wax 4 cars or wash 2 cars, so her opportunity cost of washing one car is 2 (or 4/2) wax jobs.

Because Ishana‘s opportunity cost of washing a car is lower than Ted‘s, Ishana has a comparative advantage in washing cars.

2. If Ted washes 12 cars, then he gives up on waxing 4 cars. So for every car he washes, he gives up on waxing 4 12 = 0.33 cars, implying that Ted‘s opportunity cost of washing one car is 0.33 wax jobs. If Ishana washes 6 cars, she gives up on waxing 3 cars. So for every car she washes, she gives up on waxing 3/6 = 0.50 cars, implying that Ishana's opportunity cost of washing one car is 0.50 wax jobs.

Because Ted‘s opportunity cost of washing a car is lower than Ishana‘s (0.33 < 0.50), Ted has a comparative advantage in washing cars.

3. In the time that it takes Isa to replace a set of brakes, 2 hours, she can complete one-half of a clutch replacement (2 hours for brakes 4 hours for a clutch). Therefore, Isa‘s opportunity cost 45 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

of replacing a set of brakes is one-half of a clutch replacement. In the time it takes Antonio to replace a set of brakes, 2 hours, he can complete one-third of a clutch replacement (2 hours for brakes/6 hours for a clutch). Therefore, Antonio‘s opportunity cost of replacing a set of brakes is one-third of a clutch replacement.

Alternatively, you can compute how many clutches or brakes each person can replace in a certain time period, such as 6 hours, and then use these quantities to compute their opportunity cost. In 6 hours, Isa can replace 1.5 clutches or 3 sets of brakes, so her opportunity cost of replacing one set of brakes is one-half of a clutch replacement (1.5/3).

Likewise, in 6 hours, Antonio can replace 1 clutch or 3 sets of brakes, so his opportunity cost of replacing one set of brakes is one-third of a clutch replacement (1/3).

Antonio‘s opportunity cost of replacing a set of brakes is lower than Isa‘s, so Antonio has a comparative advantage in replacing brakes. This also implies that Isa has a comparative advantage in replacing clutches (the opportunity cost of replacing a clutch is the inverse of the opportunity cost of replacing a set of brakes).

Finally, neither person has an absolute advantage in brake replacement since it takes Isa and Antonio the same amount of time to replace a set of brakes. Isa has an absolute advantage over Antonio in clutch replacement since it takes her less time than it takes Antonio to perform that job.

4. a. Absolute advantage belongs to the worker that can pick the most fruit in a given time period. Since Bella can pick 100 apples each day and Edward can pick only 50, Bella has an absolute advantage in picking apples.

Comparative advantage for apples belongs to the worker who can pick an additional apple with the lowest opportunity cost. For Bella, the opportunity cost of picking 100 more apples is 25 fewer bananas (one day's worth of work), so the opportunity cost of each additional apple is 0.25 or one-fourth banana (25/100). Similarly, Edward's opportunity cost of picking 50 more apples is 50 fewer bananas (one day's worth of work), so the opportunity cost of each additional apple is 1 banana (50/50). Since Bella has the lower opportunity cost for picking apples, she has the comparative advantage in picking apples. Note that each worker‘s opportunity cost of picking one more banana is the inverse of his or her opportunity cost of picking one more apple, so Edward has the lower opportunity cost for picking bananas (1 apple for Edward compared to 4 apples for Bella). b. If Bella and Edward both picked nothing but apples, they could pick 150 apples daily: 100 by Bella and 50 by Edward. With each worker working 200 days per year, the total number of apples picked annually would be 30,000 (150 × 200). Similarly, if Bella and Edward both picked nothing but bananas, they could pick 75 bananas daily: 25 by Bella and 50 by Edward. With each worker working 200 days per year, the total number of bananas picked annually would be 15,000 (75 × 200).

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If each worker fully specializes according to his or her comparative advantage, Bella would pick nothing but apples, and Edward would pick only bananas. After 200 days, they would have 20,000 apples (100 × 200) picked by Bella and 10,000 bananas (50 × 200) picked by Edward.

5. a. The word price of shoes is $10 a pair, so that a foreign worker can earn $5,000 ($10 × 500) annually by working in the shoe industry. The world price of a robot is $5,000, so that a foreign worker can also earn $5,000 ($5,000 × 1) annually working in the robot industry. b. A U.S. worker can produce either 10 industrial robots or 1,000 pairs of shoes per year, so the opportunity cost for one robot is 100 pairs of shoes: if 10 robots = 1,000 pairs of shoes, then 1 robot = 1,000/10 shoes. Similarly, a foreign worker can produce either 1 industrial robot or 500 pairs of shoes per year, so the opportunity cost for one robot is 500 pairs of shoes. Since U.S. workers have the lower opportunity cost for producing robots, the U.S. has a comparative advantage in the production of robots, and the U.S. will export robots. The opportunity cost for a pair of shoes is 0.01(= 10/1,000) robots for a U.S. worker and 0.002 (= 1/500) robots for the foreign worker. Since U.S. workers have the higher opportunity cost of producing shoes, the U.S. will import shoes. c. Before the opening to trade, a U.S. worker's income will buy 1,000 pairs of shoes ($30,000/$30 = 1,000) or 10 robots ($30,000/$3,000 = 10). Since the world price for industrial robots is $5,000, when the U.S. is open to trade, each worker will earn $50,000 ($5,000 × 10) making robots. That $50,000 is enough to buy 5,000 pairs of shoes ($50,000/$10 = 500), or 10 robots ($50,000/$5,000 = 10). So buying power in terms of robots is unchanged, but in terms of shoes, it has quintupled. Even though they are trading with foreign workers who earn much less than they do, U.S. workers are made better off by trade. d. In the short term, it might be costly for workers in the shoe industry to switch to the robot industry. The best policy response, however, is not to block trade (which increases consumer buying power in both the U.S. and abroad). Instead, the government could help facilitate the transition by reducing the costs associated with switching industries. This might include helping workers acquire new skills or relocate to a new area.

6. a. As seen in the graph below, the quantity of automobiles demanded and supplied both equal 17,000 at a price of $14,000. So this is the market equilibrium if the economy is closed.

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b. If the economy opens to trade, then the world price of automobiles becomes the domestic price. At the world price of $8,000, the domestic quantity demanded will be 20,000 cars per year, and domestic quantity supplied will be 14,000 cars per year. This difference (20,000 – 14,000) is made up by importing 6,000 foreign-produced cars. The opening of the automobile market to trade will be favored by domestic consumers, who will buy more cars at a lower price. Domestic producers, however, will oppose the opening of the automobile market to trade because they will be forced to lower the price of their cars to compete with cheaper foreign imports. c. When the government imposes a tariff of $2,000 per car, the domestic price paid for cars increases to $10,000, and as a consequence, the domestic quantity demanded decreases to

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19,000 cars per year, and the domestic quantity supplied increases to 15,000 cars per year.

d. As a result of the tariff, the quantity of imports decreases to 4,000 cars per year (19,000 – 15,000). Since the government collects $2,000 per car and 4,000 cars are imported, $8 million ($2,000 × 4,000) in revenue will be raised by the tariff. Domestic producers will favor the imposition of the tariff since they are now able to sell more cars at a higher price, while domestic consumers will oppose the tariff as cars are now more expensive.

7. a. When the economy is open to trade, the world price of automobiles becomes the domestic price. At the world price of $10,000, the domestic quantity demanded is 19,000 cars per year, and domestic quantity supplied is 15,000 cars per year. This difference (19,000 – 15,000) is made up by importing 4,000 foreign-produced cars.

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b. If the government imposes a quota on automobile imports of 2,000 cars per year, the total number of cars available to domestic consumers will be the number of cars produced by domestic producers plus the 2,000 imported cars. The total number of cars available to domestic consumers after the quota is illustrated by the new supply curve in the graph above. The domestic demand curve and the "Domestic supply plus quota" curve intersect at a price of $12,000 per car. At this higher price, the domestic quantity demanded decreases to 18,000 cars per year, and the domestic quantity supplied increases to 16,000 cars per year. So, as expected, the quota leads the quantity of imports to fall to 2,000 (= 18,000 – 16,000) cars per year, which is the legal limit on imports.

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quota. Domestic producers will be able to sell more cars at a higher price, and those with an import license can pocket an extra $2,000 per car—the difference between the domestic price of $12,000 and the world price of $10,000. Domestic consumers will oppose the quota as it makes cars more expensive.

8. You should reject the trade agreement if your election as president depends on how many votes you get in an election. The union representing manufacturing workers can deliver more votes than the union representing tourism workers; since the union representing manufacturing workers opposes the trade agreement, you should take their side in order to get their votes.

CHAPTER 12

MACROECONOMICS: A BIRD’S-EYE VIEW OF THE ECONOMY

Answers to Review Questions 6. The catastrophic economic collapse of the 1930s convinced economists and policymakers that there were major gaps in their understanding of how the economy works, and of how government policy can be used to address problems such as high unemployment.

Understanding the Depression also seemed to require studying the economy at the national level, rather than at the level of individual firms, consumers, and markets. Hence the Depression provided a major motivation for the creation of macroeconomics, the study of national economic performance and the policies used to improve that performance.

7. On average, citizens of the United States, together with those of other industrialized nations (such as Japan and the Western European countries), today enjoy a very high standard of living, particularly in comparison with the poorest developing nations. This high standard of living is the result of strong economic growth in the industrialized countries over the past century or more. For example, output per person in the United States is more than 16 times what it was less than a century ago. This large increase in output per person is reflected in major changes in the way the typical person lives, not only in terms of access to consumer goods, but also in terms of other measures of quality of life, such as levels of health and education.

8. Average labor productivity is output per employed worker. Because the amount we can consume is determined by the amount that we produce, increases in output per worker are a principal source of improvements in living standards. In the United States, output per employed worker has increased by more than four times since its level in 1965. (The fact that output per person has risen even faster reflects the fact that a higher proportion of the population has a job today than in the past.)

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9. False. Economic growth does not proceed at a constant rate but sometimes slows down or speeds up for a time. Slowdowns in economic growth are called recessions (or, in particularly severe cases, depressions), and speedups in economic growth are called expansions (particularly rapid speedups are called booms). The causes of recessions and expansions are an important question in macroeconomics.

10. False. Objective analysis of the issues can often resolve debates about the likely effects of a proposed policy (positive analysis). But objective analysis does not address the question of whether a policy should be enacted (a normative question). Determining whether a policy should be enacted usually involves debates about personal values (for example, as to whether the likely consequences of the policy are desirable), which cannot be resolved by purely objective analysis.

11. a. b. c. d. e.

Structural Fiscal Monetary Fiscal Structural

12. Baseball statistics calculated for the individual, the team, or the league are used to answer different questions. For example, an individual player‘s batting average is useful for assessing the player‘s performance. The team‘s batting average provides information about the performance of the team‘s batting coach or of the team management (which assembled the team). League batting statistics give information about the broad effects of changes in rules, styles of play, etc. For example, when league home run totals skyrocketed in 2000, the question arose as to whether the ball had become livelier, or whether other changes (such as league expansion) were responsible for the increased offense. Calculating statistics for groups of players (teams, leagues) is an example of aggregation. As in macroeconomics, aggregation of statistics permits a ―bird‘s-eye view‖ of developments and trends.

Answers to Problems 12. Slowing population growth and an increased share of retired people both imply slower growth in the number of people employed. If average labor productivity (output per employed worker) continues to grow at earlier rates, total output will still grow more slowly than before, because of slower growth in the number of workers. If average labor productivity stagnates, then total output will grow very slowly or even decline.

Living standards depend not on total output but on output divided by the total population.

Slowing population growth reduces total output but also the number of people who share that output. So slower population growth, or a decline in the total population, should not in itself 52 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

affect living standards. However, a reduced share of the population that is working, all else equal, will reduce output per person, lowering living standards. Slower or no growth in productivity will only worsen this problem.

13. It is possible, if the decline in average labor productivity (output per worker) is offset by an increased share of the population that is employed. For a simple example, suppose an economy has two people, one of whom is working. The one worker produces 10 units of output, so average labor productivity is 10. Output per person (10/2) is 5. Now suppose that average labor productivity drops to 8 but both people are working. Then total output is 16 and output per person is 8, so average living standards (output per person) rise even though average labor productivity (output per employed worker) has fallen.

14. Answers will vary.

15. a. Positive. This is a prediction of the effect of the interest rate policy, and not a value judgment on whether the policy should be used. b. Normative. Words like "should" and "acceptably low" express value judgments about the policy. c. Positive. The statement is a prediction of the likely effects of an event, the economy slowing, and does not express any value judgments or recommendations on what should be done in response to this event d. Positive. The statement is a prediction of the likely effects of a policy, not a recommendation on whether the policy should be used. e. Normative. The statement is about the desirability of certain types of policies, not their likely effects.

16. a. The worldwide operations of General Motors would be studied by a microeconomist as General Motors, as this pertains to an individual firm. b. The effect of government subsidies on sugar prices would be studied by a microeconomists, since this issue relates to the supply and demand for a specific good— sugar. Note that while the actions of the government are also sometimes studied by macroeconomists, this particular issue does not pertain to the national or aggregate economy. c. Factors affecting average wages in the U.S. economy would be studied by a macroeconomists. Average wages across the economy is an aggregate concept, as it pertaining to the national economy.

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d. Inflation in developing countries would be studied by a macroeconomists, as inflation is an aggregate, economywide concept. e. The effects of tax cuts on consumer spending would be studied by a macroeconomists.

Government tax policies and consumer spending are aggregate concepts pertaining to the national economy.

CHAPTER 13 MEASURING ECONOMIC ACTIVITY: GDP, UNEMPLOYMENT, AND INFLATION Answers to Review Questions 1. Economists use market values when calculating GDP because this makes it possible to add together, or aggregate, different goods and services to get a measurement of total output. For example, we can‘t add together apples, bananas, and shoes, but we can add together their market values.

The economic rationale for giving high-value items more weight in GDP than low-value items is that the market price of each item is a measure of the value that its purchasers place on it. For example, a car is probably worth more to the average person than a cheeseburger, and GDP takes this into account through the fact that a $20,000 automobile counts for 5,000 times as much in GDP as a $4 double cheeseburger.

2. Answers will vary; here are some common examples:  Consumption: consumer goods and services such as clothing, food, cars, haircuts, and dry cleaning.  Investment: purchase of a factory, a machine or other form of capital. Changes in the value of a nation‘s inventories and new residential construction (homes, apartment buildings) are also examples of investment spending.  Government purchases: goods or services acquired by the government, such as military hardware or the services of public-school teachers. Transfer payments (e.g. Social Security payments) are not included in this category.  Net exports: exports less imports, for example, U.S.-grown wheat purchased by India (an export) or a German car purchased by a U.S. citizen (an import).

Consumption represents the largest share of GDP of the four components. The only two components that can be negative are net exports (if imports exceed exports, as they have in the U.S. for most of the past 25 years) and inventory investment (if value of inventories fall during the course of a year).

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Last year: (1,000 polishes)($4 per polish) = $4,000 This year: (1,200 polishes)($5 per polish) = $6,000 Real GDP using last year as the base year: Last year: (1,000 polishes)($4 per polish) = $4,000 (Note that real GDP and nominal GDP are always the same for the base year).

This year: (1,200 polishes)($4 per polish) = $4,800 Sara‘s contribution to real GDP has grown by 20% since last year ($4,800 $4,000 = 1.20), which is the same as the increase in the physical volume of her output (1,200 polishes/1,000 polishes = 1.20). Real GDP is therefore the better statistic to use when measuring Sara‘s change in productivity since it eliminates the effects of price changes and measures the physical volume of production.

4. The costs of a high unemployment rate include economic costs (e.g. loss of output), psychological costs (e.g., depression and loss of self-esteem on the part of unemployed workers), and social costs (e.g., increases in crime). There is much debate regarding the effects of increased government assistance. For instance, more generous government benefits would probably increase or prolong the economic costs to society of unemployment, as unemployed workers would face less incentive to find work quickly. However, these costs would be borne less by the unemployed themselves and more by taxpayers thus spreading the burden among more people. Increased government support would probably reduce some psychological costs (anxiety about feeding one‘s family) and increase others (loss of selfesteem induced by taking ―charity‖). Some social costs, such as the costs of crime, would probably be reduced by providing a higher level of income support to the unemployed.

5. The official cost-of-living index, the CPI, measures the cost of buying a particular ―basket‖ of goods and services, relative to a specified base year. The official basket of goods and services is intended to correspond to the buying patterns of the typical family. A family whose buying patterns differ from the average may find that changes in its cost of living are not well captured by the official CPI. For example, if the price of peanut butter rises sharply, the cost of living for a family that buys much more peanut butter than the typical family will increase more than the CPI, all else being equal.

6. It is important to adjust for inflation when comparing nominal quantities at different points in time because with inflation, increases in nominal quantities may simply reflect higher prices rather than increased production or purchasing power. For example, a 10 percent increase in a worker‘s nominal wage implies a 10% increase in purchasing power if prices are unchanged, but no increase in purchasing power if prices have also risen by 10 percent.

The basic method of adjusting for inflation, called deflating the nominal quantity, is to divide a nominal quantity by a price index, such as the CPI. For example, the real wage is equal to

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the nominal wage divided by a price index and measures the purchasing power of the wage.

Unlike nominal wages, real wages can be meaningfully compared over time.

7. First, quality adjustment bias occurs when government statisticians underestimate quality improvements. For example, if candy bars weigh 10 percent more than last year and also cost 10 percent more, there is no true inflation in candy bar prices since the price per ounce is unchanged. However, if the statisticians fail to note the increase in weight and simply record the 10 percent increase in price, they will mistakenly overstate inflation. The more subtle improvements in quality are (for example, more effective medical procedures), the harder they are to measure precisely, which increases the risk of overstating inflation.

Second, substitution bias occurs because the CPI assumes a fixed basket of goods and services that does not allow for the possibility of consumer substitution of less expensive items for more expensive ones. For example, if a particular type of candy bar is included in the official basket, and the price of this candy bar rises, then an increase in the official cost of living will be recorded. However, if people can switch from one type of candy bar to another desirable that has not increased in price, then the ―true‖ cost of living will not have risen despite what the CPI shows.

8. The first two sentences are correct; the losses that unanticipated inflation imposes on creditors (for example) are just offset by the gains to debtors. The third sentence is not correct, however, as there is an overall cost to society when wealth is redistributed arbitrarily.

First, the role of luck in the distribution of income is increased since the size of one‘s return depends on whether inflation is high or low; this makes people feel worse off and is a cost to society. Second, when wealth is determined more by random forces than by hard work and intelligent investment, the incentives to engage in the latter are reduced, harming the efficiency of the economy. Finally, people use up resources attempting to anticipate inflation and protect themselves against it; from society‘s point of view, these resources are wasted.

Answers to Problems 1. GDP is the market value of production, and is equal to: (300 fish)(3 clamshells per fish) + (5 boars)(10 clamshells per boar) + (100 bunches of bananas)(10 clamshells per bunch of bananas) = 900 + 50 + 1,000 = 1,950.

John digging bait for George represents an intermediate service that is not counted in GDP. Similarly, George‘s purchase of mature banana trees does not count in GDP since the trees are an existing asset.

2. a. $1 billion in salaries for government workers is a government purchase of a service. GDP increases by $1 billion.

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b. $1 billion to Social Security recipients is a transfer payment. Transfer payments are not counted in GDP, so this transaction does not affect GDP. c.

$1 billion for newly produced airplane parts is a government purchase of a good. GDP increases by $1 billion.

d. $1 billion in interest to holders of U.S. government does not count because interest payments by the government are not included in GDP, so this transaction does not affect GDP. e. $1 billion to Saudi Arabia for crude oil to add to U.S. government-owned oil reserves counts in two categories of GDP. First, the purchase counts as a $1 billion government purchase of goods. Second, since the oil is purchased from Saudi Arabia, imports rise by $1 billion and therefore net exports fall by $1 billion. Thus, there is no net effect on GDP as the government purchase is exactly offset by the decrease in net exports. (Note: This makes sense, since no additional production occurred within the United States.)

3. a. Value-added for 2019 is shown in the following table: Company MNLogs MNLumber MNFurniture

Revenues 1,500 4,000 7,000

Cost of purchased inputs 0 1,500 4,000

Value added 1,500 2,500 3,000

b. The increase in GDP for 2019 equals the sum of the value added, which is $1,500 + $2,500 + $3,000 = $7,000 c. Value-added for 2019 is shown in the following table: Company

Revenues

MNLogs

1,500

Cost of purchased inputs 0

Value added 1,500

Value-added for 2020 is shown in the following table: Company MNLumber MNFurniture

Revenues 4,000 7000

Cost of purchased inputs 1,500 4000

Value added 2,500 3000

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The increase in GDP for 2020 equals the sum of the value added in 20120, which is $2,500 + $3,000 = $5,500.

4. a. U.S. GDP and consumption both rise by the value of the new car. b. U.S. consumption rises by the value of the car and U.S. net exports fall by the value of the car (since U.S. imports rise by the value of the car.) Therefore, there is no change in U.S. GDP. c. U.S. GDP and investment both rise by the value of the car since the purchase of a car by a business counts as investment. d. U.S. investment rises by the value of the car and U.S. net exports fall by the value of the car (since U.S. imports rise by the value of the car). Therefore, there is no change in U.S. GDP. e. U.S. GDP and government purchases both increase by the value of the car.

5. The key to this problem is to find the four components of expenditure: 1. Consumption expenditures are $550. These already include the $150 worth of household purchases of durable goods, so those would not be counted again.

2. Investment expenditures are $225. This is the sum of residential construction ($100) plus business fixed investment ($100) plus inventory investment (change in inventory stocks over the year, or 25). Sales of existing homes and apartments are not counted in investment or GDP. 3. Government purchases are $200. Government payments to retirees are transfer payments and are not counted.

4. Net exports are $25. Net exports equals exports ($75) minus imports ($50).

GDP is the sum of the four components: $550 + 225 + 200 + 25 = $1,000.

6.

For the year 2017: Nominal GDP = (100 pucks)($5 per puck) + (300 cases of root beer)($20 per case) + (75 pairs of sandals)($20 per pair) Nominal GDP = $8,000 Real GDP (using prices from 2017) = $8,000 ** Notice that nominal GDP and real GDP are always the same for the base year.

58

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For the year 2020: Nominal GDP = (125 pucks)($9 per puck) + (325 cases of root beer)($20 per case) + (110 pairs of sandals)($25 per pair) Nominal GDP = $10,375 Real GDP (using prices from 2017) = (125 pucks)($5 per puck) + (325 cases of root beer)($20 per case) + (110 pairs of sandals)($20 per pair) Real GDP (using prices from 2017) = $9,325 Nominal GDP and real GDP rose from 2017 to 2020.

7.

In the sample the sample of 65 people, the 10 children under age 16, the 10 retired people, the 5 full-time homemakers, the 5 full-time students, and the 2 disabled people are not in the labor force. Of the remaining 33 people, 30 people are employed (either part-time or fulltime). This leaves three people who do not have jobs but would like to work. One of these three people has not looked for work for three months and so is counted as not in the labor force rather than unemployed; the other two people are unemployed.

Thus, we have the following:  The working-age population is 55 (65 people minus 10 children under 16).  23 people are over 16 but not in the labor force (including the one person who has not looked for work for three months).  32 people are in the labor force.  30 people are employed.  2 people are unemployed.

The unemployment rate is computed by dividing the number of unemployed (2) with the labor force (32), which is 0.0625, or 6.25 percent.

The participation rate is computed by dividing the labor force (32) with the population over 16 (55), which is 0.5818, or 58.18 percent.

8. The participation rate is 62.5 percent, so that implies that 62.5 percent of the working-age population is in the labor force and the remaining 37.5 percent is not in the labor force.

We know that 63 million people are not in the labor force, so the total working-age population must be 168 million (63 million is 37.5% of population not in the labor force, or 63/0.375 = 168).

The labor force is 62.5% of 168 million, or 105 million people (168 × 0.625).

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The unemployment rate is 5.9 percent of the 105 million people in the labor force, which equals 6,195,000 people. Therefore, the remaining 98,805,000 people in the labor force must all be employed.

9. a.

The cost of the goods in the base year is $250 + $600 + $100 + $50 = $1,000. In the subsequent year the same goods costs $275 + $700 + $120 + $40 = $1,135. The CPI in the subsequent year equals the cost of the goods in that year relative to the base year: $1,135 / $1,000 = 1.135.

Since the CPI in the base year is 1.000, the rate of inflation (equal to the percentage increase in the CPI) between the base year and the subsequent year is 13.5 percent.

b. The family‘s nominal income rose by 5%, which is less than the increase in the family‘s cost of living. The family is thus worse off in terms of real purchasing power.

10. The inflation rate between 2000 and 2001 is the percentage increase in the price level between those years: (128.2 – 122.7)/122.7 = 4.5%. Inflation rates for the years 2001 through 2010 are presented below.

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

CPI 122.7 128.2 132.3 136.5 140.2 144.4 148.9 152.5 155.0 158.6 164.2

Inflation Rate (%) 4.5 3.2 3.2 2.7 3.0 3.1 2.4 1.6 2.3 3.5

Inflation rates were relatively low throughout the 2000s. Inflation was at its lowest in 2008. It went up a little in 2009 but increased by more than a percentage point in 2010.

11. The real median income is determined by dividing the nominal income by the CPI for the given year and multiplying the result by 100. The results for each year are given in the table below:

Year 1985 1995

Nominal Income $23,618 $34,076

CPI 107.6 152.4

Real Income $21,949.81 $22,359.58

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2005 2010

$46,326 $49,276

195.3 218.1

$23,720.43 $22,593.31

Based on the information in the table, real median household income rose between 1985 and 2005, but then declined between 2005 and 2010.

12. Using the CPI data from the table above, the real entry-level wage for college graduates in 1997 was: $13.65/1.605 = $8.50.

Since the real wage fell by 8 percent between 1990 and 1997, the $8.50 real wage in 1997 was 92 percent of the real wage in 1990: 8.50 = 0.92 × real wage in 1990 Real wage in 1990 = $9.24.

Let W1990 stand for the nominal wage in 1990. Then, if we deflate the nominal wage by the CPI, we have: W1990/1.307 = $9.24.

Solving for W1990 gives us a nominal wage in 1990 of $12.08.

Note this problem was updated in Connect and in subsequent printings of this book. The question was changed as follows: Refer to the CPI data given in Problem 10. A recent report found that the real entry-level wage for college graduates declined by 5 percent between 2003 and 2010. The nominal entry-level wage in 2010 was $13.65 per hour. a. What was the real entry-level wage in 2010? b. What was the real entry-wage in 2003? c. What was the nominal entry-level wage in 2003?

Solution as follows: a. Using the CPI data from problem 10, the real entry-level wage for college graduates in 2010 was $14.35/1.642 = $8.74 b. Since the real wage fell by 5 percent between 2003 and 2010, the $8.74 real wage in 2010 was 95 percent of the real wage in 2003: 8.74 = 0.95 × Real wage in 2003 Real wage in 2003 = $9.20 c. Let W2003 stand for the nominal wage in 2003. Then, if we deflate the nominal wage by the CPI, we have W2003/1.365 = $9.20. Solving for W2003 gives us a nominal wage in 1990 of $12.56.

13. a. Because the two percent increase in nominal income is just enough to offset the

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two percent increase in the general cost of living, as measured by the official inflation rate, the real income is constant in both nations. In other words, the increase in real or relative income is zero in both nations (2% − 2%). b. Since Economy A continues to consume a basket of goods that is pretty much unchanged from year to year, price changes in that basket should be a pretty accurate measurement of "true" inflation. However, the frequent improvements in the quality of the basket of goods consumed in Economy B, makes it hard do determine if the increases in the prices of goods are due to higher quality of goods or because the same product is simply costing more (true inflation). The official inflation rate is therefore more likely to overstate true inflation in Economy B, which would also imply that the improvements in living standards are understated in Economy B.

14. The fourth column in the table below shows the real price of gasoline, calculated as the nominal price of gasoline divided by the CPI. The fifth column shows the year-to-year percentage change in the real price of gasoline, and the sixth column shows the inflation rate (i.e., the year-to-year percentage change in the CPI).

Year 1978 1979 1980 1981 1982 1983 1984 1985 1986

Gasoline price ($/gallon) 0.663 0.901 1.269 1.391 1.309 1.277 1.229 1.241 0.955

CPI (1982-1984 = 1) 0.652 0.726 0.824 0.909 0.965 0.996 1.039 1.076 1.136

Real price of gasoline 1.017 1.241 1.540 1.530 1.356 1.282 1.183 1.153 0.841

Percentage change in real price of gasoline

Inflation

22.0% 24.1% -0.6% -11.4% -5.5% -7.7% -2.5% -27.1%

11.3% 13.5% 10.3% 6.2% 3.2% 4.3% 3.6% 5.6%

The table shows that a large part of the fluctuations in oil prices reflected changes in the real price of gas, rather than general inflation. Most striking, the real price of gas fell 27 percent in 1986 while the inflation rate was 5.6 percent.

CHAPTER 14

ECONOMIC GROWTH, PRODUCTIVITY, AND LIVING STANDARDS

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Answers to Review Questions 1. Since 1870 real GDP per person has grown more than tenfold in the U.S. and many other industrial countries and by 25-fold in Japan. These large increases in output per person have led to substantial increases in the material standard of living of the average person in these countries. By contrast, growth has been much slower in countries such as Ghana, which has led to a widening gap in standards of living between the high-income and low-income countries.

2. Average labor productivity times the share of the population that is employed equals real GDP per person. Real GDP per person is a basic determinant of long-run living standards.

The share of the population that is employed can only increase so much, given the fact that there are always children, retired people, etc. Thus, large long-term gains in real GDP per person, and hence living standards, must come from increases in average labor productivity.

3. Human capital is the talents, education, training, and skills of workers. Human capital is important because workers with more human capital are more productive, implying higher levels of output per worker and higher living standards. New human capital is created through ―investment in people‖, as when individuals spend time and money acquiring an education, or an employer devotes resources to training workers.

4. To get the most output (in terms of ditches dug), you should give the first shovel to the strongest worker, the next shovel to the second strongest worker, and so on until you run out of shovels. Because a stronger worker can make better use of a shovel than a worker who is weaker, this strategy is consistent with the Low-Hanging Fruit Principle: limited resources should be devoted first to their most productive uses. Since workers without shovels produce nothing, the more shovels you have, the more total output and output per worker will be produced; thus extra capital (shovels) enhances average labor productivity. However, because an extra shovel will be used by a worker who is weaker than those who already have shovels, the extra output made possible by each additional shovel is declining, which is what is meant by the term ―diminishing returns to capital.‖

5. This is a normative issue, so there will be various answers. The text points out ways in which GDP fails to measure important aspects of economic well-being such as the value of leisure time, non-market economic activities, environmental quality and resource conservation, and ―quality-of-life‖ indicators such as a low crime rate, and economic inequality. On the other hand, GDP does measure the availability of goods and services and is strongly related to other measures of well-being, such as nutrition, health, and years of schooling.

6. The most straightforward is the cost of creating new capital. We know that by expanding the capital stock we can increase future productivity and output. But, to increase the capital 63 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

stock, we must divert resources that could otherwise be used to increase the supply of consumer goods.

7. Policies that governments can use to promote growth include the following:  encouraging the development of human capital (for example, by support of education);  encouraging high rates of saving and investment (for example, through tax breaks);  making public investments in infrastructure (such as highways, bridges, and communications networks);  supporting basic research;  providing a political and legal environment conducive to growth, including a stable political system, well-defined property rights, free and open exchange of ideas, and a tax and regulatory system favorable to entrepreneurship and other economically productive activities.

8. Environmental fragility and limited resources may impose limits on the expansion of current types of economic activities (e.g. more and more cars, more and more coal-fired power plants.) Global environmental problems, such as global climate change, are not handled very well by the market or by individual national governments and are definitely cause for concern. However, there are reasons to believe that that the ―limits to growth‖ thesis may be overstated. These include, but are not limited to, the following:  Economic growth includes the development of better and more efficient products and services, which may be less taxing on the environment than current products;  economic growth provides additional resources that can be used to help protect the environment;  market mechanisms will tend to alleviate shortages of resources by dampening demand and encouraging supply, as happened in the 1970s energy crisis and seems to have happened in the beginning of the 21st century as oil prices rose prior to the Great Recession.

Answers to Problems 1. After one year, Richland‘s real GDP per person equals ($40,000) × (1.01); after two years it equals ($40,000) × (1.01) × (1.01) = ($40,000) × (1.01)2, and so on. After ten years, Richland‘s GDP per person equals ($40,000) × (1.01)10 = $44,184.89, and after twenty years it equals ($40,000) × (1.01)20 = $48,807.61.

Poorland‘s GDP per person after ten years is ($20,000) × (1.03)10 = $26,878.33, and after twenty years it equals ($20,000) × (1.03)20 = $36,122.22. Thus, Poorland has gone from half the level of income of Richland to about three-quarters the level of Richland in twenty years.

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Suppose that GDP per person in Richland and Poorland are equal after t years; our objective is to find t. After t years Poorland‘s GDP per person is ($20,000) × (1.03)t, and Richland‘s GDP per person is ($40,000) × (1.01)t. Setting these two expressions equal, and dividing both sides by $20,000, we get (1.03)t = 2 × (1.01)t By solving the above equation for t, we find that Poorland catches up in between 35 and 36 years. Note that this value can also be found graphically or by trial and error.

(1.03)t = 2 × (1.01)t (1.03/1.01)t = 2 t x ln (1.03/1.01) = ln2 t = ln2/ln1(1.03/1.01) t = 35.349

2. Let yt stand for labor productivity in year t. If labor productivity grows at the rate g, then y2035 = y2015(1 + g)20 Re-writing this equation, we have

y 2035  (1  g ) 20 y 2015 a. When g = 0.031 (i.e. 3.1%), the ratio of y2035 to y2015 is 1.842. So, if labor productivity is $100,000 in 2015, it will rise to about 184,200 in 2035. b. When g = 0.014 (i.e. 1.4%), the ratio of y2035 to y2015 is 1.321. So, if labor productivity is $100,000 in 2015, it will rise to about $132,100 in 2035. c. When comparing the two estimates for labor productivity, we find that the higher growth rate yields a labor productivity that is 1.39 times higher ($184,200/$132,100) per worker.

3. Real GDP per person in 2016 = Average labor productivity 2016 × share of population employed = $110,38 × 0.468 = $51,660 Between 1960 and 2016 average labor productivity grew from $47,263 to $110,384, a gain of 133.55 percent. If productivity grows by the same rate over the period 2016–2072, in 2072 it would equal (1.3355) × $110,384 + $110,384, or $257,802. To find real GDP per person in 2072, we multiply this number by the share of the population that is employed, which we assume will be 0.364, the same as in 1960: Real GDP per person in 2066 × share of population employed = $252,120 × 0.364 = $93,840.

Thus, the 2072 real GDP per person is $42,180 higher ($93,840 – $51,660) or 81.6 percent ($42,180 / $51,660) higher than in 2016. Output per person will be higher in 2072 compared to 2016, but not as high as the increase in labor productivity since a smaller share of the population will be working in 2072 compared with 2016.

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4. Take the average labor productivity times the share of the population that is employed equals real GDP per person. Thus, average labor productivity equals real GDP per person divided by the share of the population employed. Using the data from the first two columns of the table below, along with the employment to population ratios from the problem, we can calculate average labor productivity, shown in the last two columns.

Germany Japan

GDP per capita 1980 2010 $14,114 $20,661 $13,428 $21,935

Employment to population 1980 2010 0.33 0.52 0.48 0.49

Average labor productivity 1980 2010 $42,770 $39,733 $27,975 $44,765

In Germany, GDP per capita increased solely because of the rise in the employment-topopulation ratio, as the average labor productivity actually decreased slightly between 1980 and 2010. By contrast, in Japan virtually all of the increase in GDP per person was due to increased labor productivity as the employment-to-population ratio was virtually constant.

5. a. If Joanne goes to work, she will earn $20,000 per year for the next five years.

After living expenses she will save $5,000 per year, so at the end of the five years she will have savings of $25,000 (assuming zero interest earnings). If she goes to community college, she‘ll earn $38,000 a year in years 3-5, for a total of $114,000. Subtracting five years‘ living expenses ($75,000) and student loan repayments ($12,000), she will be left with $27,000 in savings at the end of the five years. So, she should go to community college. Note that Joanne‘s objective of maximizing her savings after five years takes no account of what is perhaps an even stronger economic incentive for further education, which is that after 5 years she will have a $38,000 per year job rather than a $20,000 per year job. b. If Joanne can earn $23,000 per year with a high school degree, she will be able to save $8,000 per year, leaving her $40,000 at the end of five years. If Joanne goes to community college, she will have savings of $27,000 after five years, as we found in part a. So in this case, she should not make the investment of furthering her education. Economically speaking, her opportunity cost of two years in community college is higher when she can earn $23,000 rather than $20,000 by going directly to work. c. If tuition and books cost $8,000 per year, Joanne will have to repay $16,000 in student loans rather than $12,000, and her savings at the end of five years will be $114,000 – $75,000 – $16,000 = $23,000, less than the $25,000 in savings she will have if she goes directly to work. A higher cost of obtaining an education makes doing so less economically attractive. d. If she goes directly to work, Joanne will add $5,000 to her savings at the end of each year, years 1 to 5. The table below shows the value of each deposit at the end of 5 years along with the total value of her savings at the end of 5 years: 66 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Year deposit of $5000 is made: 1 2 3 4 5 Total

Value of deposit at end of 5 years: $7,320.50 $6,655.00 $6,050.00 $5,500.00 $5,000.00 $30,525.50

If Joanne goes to college, at the end of year 1 she will have a debt of $21,000 (living expenses plus tuition and books). At 10% interest, at the end of year 5 this debt will have grown to ($21,000) × (1.10)4 = $30,746. Another debt of $21,000 at the end of year 2 will have grown to ($21,000) × (1.10)3 = $27,951 by the end of year 5. In years 3 – 5, Joanne will earn $38,000 and spend $15,000 on living expenses, saving $23,000 each year. At the end of 5 years the value of these savings will be ($23,000) × (1.10)2 + ($23,000) × (1.10) + $23,000 = $27,830 + $25,300 + $23,000 = $76,130.

Subtracting Joanne‘s debts of $30,746 and $27,951 from her saving yields $17,433 in assets at the end of five years, which is less than if she skips community college. So, on purely economic grounds, Joanne should go directly to work. This example illustrates that a higher interest rate reduces the value of activities that involve incurring costs now in exchange for higher benefits later.

6. a. With four employees and two lanes, both lanes have a checker and a bagger. Total output is 84 customers per hour. Average labor productivity is: 84 customers per hour/ 4 workers = 21 customers per hour per worker. b. A bagger increases output by 17 customers per hour (the difference between the 42 customers serviced by a checker and a bagger and the 25 customers served by a checker alone.) If there is an empty lane available, a checker working alone increases output by 25 customers. So, the best strategy is to take one of the baggers and make him or her a checker in the new lane. Total output is then 92 customers per hour (42 for the checker and bagger plus 25 for each checker working alone) and average labor productivity is 23 customers per hour. Note that adding capital (the extra lane) increases both total output and average labor productivity. c. With four lanes, all four employees become checkers. Total output is 100 customers and average labor productivity is 25 customers per hour.

Because there are only four employees, a fifth lane adds no output (average labor productivity remains 25 customers per hour). We therefore do observe diminishing returns to capital, at least for the fifth lane: Adding a third lane increased output by 10 67 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

customers per hour, as did adding a fourth lane. However, adding a fifth lane does not increase output further.

7. a. As a team, the three painters can paint 280 square feet in 3 painter-hours. So productivity is 280/3 = 93.3 square feet per painter-hour. b. The first roller should be given to Fred, as it increases his production by the largest amount. The second and third rollers should be given to Harrison and Carla (in either order). There is no one to use the fourth roller. With this information we can calculate total output for the team per hour and total output per painter-hour as follows: Number of rollers 0 1 2 3 4

Output by team 280 400 500 600 600

Output per painterhour 93.3 133.3 166.7 200.0 200.0

The first roller increases the team‘s output by 120, the second increases it by 100, the third by 100, and the fourth by zero. Since the extra output produced by an extra roller declines with more rollers (except for the third roller, which has the same addition to output as the second), we observe diminishing returns to capital. c. With the technological improvement, the table in part b becomes Number of rollers 0 1 2 3 4

Output by team 336 480 600 720 720

Output per painterhour 112 160 200 240 240

After the technological improvement, the first roller increases the team‘s output by 144, the second by 120, the third by 120, and the fourth by zero. We therefore still observe diminishing returns to capital, but the economic value of the additional rollers has increased since each roller adds more output than before.

8. a. Zero, as that will allow her stock of fish to double by next year.

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b. Maximizing the growth of her stock of fish has the disadvantage that it allows Hester no current income to spend. In other words, Hester can have the benefit of a very high income and consumption next year only by starving herself this year. Similarly, the more a country is willing to ―starve itself‖ this year, by saving and investing its resources in new capital goods rather than consuming, the faster it will grow. c. To maximize her current income Hester should sell all her fish this year, realizing $5,000.

The problem with this strategy is that it leaves no source of income for the future. d. If Hester harvests none of her fish this year, she has no income this year; and if she harvests all of her fish this year, she has no income next year. Having very low or zero income in either year is very unpleasant for Hester. A better choice is to sell some fish this year, allowing for a reasonable level of current income and consumption, while leaving enough fish in the hatchery to provide for reasonable income in the future as well.

In the same way, a country should choose a rate of economic growth that balances the cost of sacrificing consumption today against the benefits of higher income and consumption in the future.

9. The reduction (if any) in real GDP is relevant when measuring the cost of the proposed policy, as it captures the loss in output. However, the benefits of the policy, in terms of cleaner air, are not captured in GDP and must be assessed in some other way (for example, by trying to value the health benefits of cleaner air). The government should apply the CostBenefit Principle in deciding whether to implement the policy; and only do so if the benefits exceed its costs.

10. a. The opportunity cost of sending children to school is inversely related to per capita income. Denmark has the highest per capita income in the table and therefore has the lowest opportunity cost, so we would expect that it would send the most children to school. Similarly, Ethiopia has the lowest per capita income and therefore has the highest opportunity cost in the table, so we would expect that it would send the fewest children to school. b. The costs of sending a child to school include expenditures on books, tuition, and fees, as well as any foregone wages while the child is in school. The benefits of sending a child to school include improved job opportunities, more job prestige due to being able to find a better job, and an enhanced ability to support the parents in old age due to the ability to get a higher paying job with more education.

11. The chapter argues that this statement is true. One way to see this point is to compare rich and poor countries in the world today. In principle, at a given time, all countries have access to the same basic scientific information. Poor countries do not benefit from existing scientific knowledge to the same degree rich countries do, however, since they lack the resources to apply the knowledge widely. For example, medical knowledge is of limited help without 69 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

hospitals, medicines, and trained personnel (not to mention adequate nutrition and sanitation). Similarly, new developments in communications and computing can be utilized only when there are sufficient resources to support an infrastructure of communications equipment, computers, and the like.

12. A good essay evaluating the U.S. economy in terms of each of the six determinants of average labor productivity discussed in the text will compare the U.S. with other countries on the basis of measures such as resource availability and quality, saving rates, public capital formation, and spending on research and development, etc.

CHAPTER 15 THE LABOR MARKET: WORKERS, WAGES, AND UNEMPLOYMENT Answers to Review Questions 1. The five trends include the following: 1. the long-term increase in real wages in industrialized countries; 2. the slowdown in real-wage growth since the 1970s; 3. increasing inequality in U.S. real wages; 4. rapid employment growth in the United States in recent decades; 5. high rates of unemployment in Europe.

The link between labor productivity and labor demand underlies the first three trends. That is, strong labor productivity growth caused labor demand to grow faster than labor supply before 1973, causing real wages to grow rapidly during that period. Similarly, the slowdown in productivity growth since the 1970s is the primary reason for the slowdown in real wage growth since the 1970s, as labor demand grew at about the same rate as labor supply. By increasing real wages, higher labor productivity improves living standards in the long term.

Increased productivity (which raises labor demand) has also contributed to rising U.S. employment, which improves living standards by giving more people a chance to earn a paycheck.

The other two trends show, however, increases in average labor productivity by themselves do not necessarily guarantee improved living standards for everyone. In the U.S., some workers have not shared in the general gains in real wages giving rise to increased wage inequality while in Western Europe potential workers have been sidelined by persistently high rates of unemployment.

2. Acme should determine the value of the extra output Marisa will produce for the firm. For example, if Marisa is a lawyer, the firm would calculate the extra revenue her billings would bring in (less costs such as the cost of her secretary and her computer). If the value of Marisa‘s marginal product is greater than or equal to $40,000, Acme will find it profitable to hire her.

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3. Strong productivity growth over the past century steadily increased the demand for labor demand at a faster rate than the growth of labor supply. Since the early 1970s, a slowdown in productivity growth has slowed the rate of increase in the demand for labor, while the supply of labor has grown more quickly, due to factors such as increased female participation in the labor market. Slower demand growth combined with more rapid supply growth has depressed real wages (though permitted strong employment growth) since the 1970s. In the past few years real wage growth has picked up again, reflecting a stronger pace of productivity growth.

4. Two factors contributing to wage inequality are globalization and skill-biased technological change. Globalization – which includes increased international trade – increases the demand for workers in export industries and lowers the demand for workers in industries that compete with imports. Wages therefore rise in export industries and fall in import competing industries, thereby increasing wage inequality. Skill-biased technical change has increased the productivity of more skilled workers relative to that of unskilled wages. The relative increase in demand for skilled workers increases the difference in wages between the skilled and unskilled.

One type of policy response is to try to block the underlying processes generating increased wage inequality by, for example, reducing globalization and international trade, or by refusing to adopt new technologies. Neither of these strategies are good public policies, since they will reduce the rate of economic growth and make the amount of economic surplus available to everyone smaller than it otherwise would be. A better set of policies is to promote the abilities of workers to change jobs; for example, by creating programs that help workers acquire the skills they need to move from low-paying to high-paying jobs (while providing income assistance to those unable to retrain).

5. Three types of unemployment are: 1. Frictional unemployment: the short-term unemployment associated with the process of matching workers with jobs in a dynamic, heterogeneous labor market.

2. Structural unemployment: the long-term and chronic unemployment that exists even when the economy is producing at a normal rate. Structural unemployment results from factors such as language barriers, discrimination, structural features of the labor market, lack of skills, or long-term mismatches between the skills workers have and the available jobs.

3. Cyclical unemployment: the extra unemployment that occurs during periods of recession.

Frictional unemployment is the least costly type of unemployment since it is usually of short duration and often economically beneficial, being part of the process by which productive matches of workers and jobs are formed.

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1. Answers will vary. If using the following data, a sample answer could be:

While workers with a bachelor's degree saw the largest dollar increase in their real wage ($13,643), the largest percent increase was seen by those workers who have no high school degree. Their average real income increased by $5,244 between 1995 and 2018, which is 24.1% ($5,244 / $21,793). However, the average wage for those without a high school degree still remains $11,537 lower than for workers with a high school degree, and $17,143 lower than the average wage for workers with a bachelor's degree.

In 1995, a worker with a bachelor's degree earned on average 1.73 (57,512/33,330) times that of a worker with only a high school degree and 2.64 (57,512/21,793) times that of a worker with a high school diploma.

In 2018, a worker with a bachelor's degree earned on average 1.83 (71,155/35,615) times that of a worker with only a high school degree and 2.63 (71,155/25,315) times that of a worker with a high school diploma.

While all three groups saw their average real wages fall during the time period 2005 and 2010, the largest percent decline was for workers who have no high school degree. These workers saw their average real income fall by $1,413 or 5.85% during this time period. The workers with a bachelor degree saw the largest dollar decrease in their real wage ($3,741), which represented a decline by 5.64% from their average real wage in 2005. For the workers with a high school degree, the dollar decline was $2,043, or 5.72%.

While the difference in average real wages between those workers who has a high school degree and those workers without is somewhat diminishing, though the workers with a diploma still earn 44% more, the difference between the average real wage of college graduates and high school graduates is increasing. Note again, how workers with a bachelor's degree earned on average 1.83 (71,155/38,936) times that of a worker with only a high school degree in 2018 compared to 1.73 times more in 1995.

2. a. The table below shows marginal products and the value of marginal products for each worker added. Since bikes sell for $130 and non-labor costs are $100 per bike, the value of a worker‘s marginal product equals $30 (= $130 – $100) times the number of additional bikes assembled.

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Number of workers 1 2 3 4 5

Output (number of bikes) 10 18 24 28 30

Marginal product (number of bikes) 10 8 6 4 2

Value of marginal product (dollars) $300 240 180 120 60

b. Bob‘s demand for labor at each wage is the same as his value of marginal product at each level of employment, that is, his labor demand is given by the first and last columns of the table in part a:

Number of workers 1 2 3 4 5

Wage= Value of marginal product (dollars) $300 240 180 120 60

c. If bikes sell for $140 each, the value of each worker‘s marginal product is $40 times his or her marginal product. The table in part b becomes:

Number of workers 1 2 3 4 5

Value of marginal product = wage (dollars) $400 320 240 160 80

d. When labor productivity increases by 50 percent, the marginal products and the values of the marginal products also rise, as shown in the table below:

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Number of workers 1 2 3 4 5

Output (number of bikes) 15 27 36 42 45

Marginal product (number of bikes) 15 12 9 6 3

Value of marginal product (dollars) 450 360 270 180 90

3. The table below shows the value of marginal product when lightbulbs sell for $2 each. These values are obtained by multiplying the marginal product, which is the additional lightbulbs produced when hiring an additional worker, multiplied by the $2 value of each finished lightbulb.

Number of workers 1 2 3 4 5 6 7 8 9 10

Marginal product: Lightbulbs per hour 24 22 20 18 16 14 12 10 8 6

Value of marginal product $48 44 40 36 32 28 24 20 16 12

a. According to the table above, the value of the marginal product of the 7th worker is $24 (12 × $2). Since each worker costs $24 per hour, the factory manager should stop hiring additional workers at this point. Note that an 8th worker would only contribute an additional $20 per hour in sales while adding $24 per hour in labor cost. If the cost of labor is increased from $24 per hour to $36 per hour, the factory will only hire 4 workers, since the value of the marginal product of the 4th worker is exactly $36 per hour. b. The demand for labor at each wage is the same as the value of marginal product at each level of employment. Note that you can verify your answers to part a using this graph.

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c. When the price or value of each lightbulb increases from $2 to $3, the value of marginal product increases too. For example, the value of the marginal product from the first worker is now $72 per hour (24 × $3). Visually, this can be seen as a rightward shift of the demand for labor. The two wage levels will now correspond to a higher number of workers demanded, as each worker contributes more value to the factory. In other words, the demand for labor has increased. d. If the supply of labor is fixed at 8 workers, then the equilibrium between the demand for labor and the supply of labor can be found in the two graphs by envisioning vertical supply curves at the quantity of 8 workers. In the first graph (when bulbs sell for $2) the equilibrium real wage would be $20, and in the second graph (when bulbs sell for $3) the equilibrium wage would be $30. Alternatively, knowing that the marginal product of the 8th worker is 10 bulbs, we can compute that the value of the marginal product for the 8th worker is either $20 (10 × $2) or $30 (10 × $3) depending on the price that the bulbs sell for. Therefore, the equilibrium real wage is $20 and $30, respectively.

4. a. An increase in the age for Medicare eligibility means that more people will continue working in order to obtain employer-paid health insurance or to earn more to be able to pay for their own health care costs. As a result, the supply of labor will increase.

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b. An increase in productivity shifts the demand for labor up. The supply of labor is unaffected. The real wage and employment rise as the economy moves along the labor supply curve. c. The draft removes people from the civilian labor force and thus reduces the supply of labor. (This effect may be offset if patriotism drives more civilians to enter the labor force, as appears to have been the case during World War II.) d. In the short run, the withdrawal of parents and caregivers from the labor force reduces labor supply. In the long run, however, more children imply a larger population and thus more workers, all else equal. e. The effect on labor supply depends on how the generosity of Social Security benefits affects people‘s retirement decisions. Assuming that people are induced by better benefits to retire earlier, labor supply falls.

5. a. An increase in demand for the type of car made by the plant raises the car‘s relative price, which raises the value of the marginal product (VMP) of the plant‘s workers. The increase in the VMP raises the demand for plant workers and therefore should increase their real wage and employment. b. The increase in gas prices lowers the demand for cars. The relative price of cars falls and therefore the value of the workers‘ marginal product falls as well. Demand for workers therefore falls, causing a decline in their real wage and employment. c. Presumably the robots represent a form of skill-biased technological change which increases the marginal product of skilled workers but reduces the marginal product of unskilled workers. Introducing robots reduces the demand for unskilled workers which lowers the real wage and employment.

6. a. The marginal product of skilled workers rises and that shifts the demand for labor to the right (assuming no change in the price of output), which causes the real wage of skilled workers to rise and the number of skilled workers employed to rise. The real wage and employment level of unskilled workers remains unchanged. Thus, the effect of the new electronic equipment is to increase the wage of skilled workers relative to the wage of unskilled workers. b. As unskilled workers acquire the skills needed to move into the skilled labor market, the supply of unskilled workers will fall. This leftward shift in supply will lead the wage of unskilled workers to rise and the employment of unskilled workers to fall. Similarly, as unskilled workers acquire skill, the supply of skilled workers will rise. This outward shift in supply will cause the wage of skilled workers to fall and the employment of skilled workers to rise. Together these movements will lead the wage gap between skilled and unskilled workers to fall.

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7. a. Structural. Ted‘s skills are mismatched with existing employment opportunities. b. Cyclical. Alice‘s unemployment is temporary and associated with a recession. c. Frictional. Tao‘s unemployment results from the process of searching for the best match between a job and his skills.

CHAPTER 16

SAVING, CAPITAL FORMATION, AND FINANCIAL MARKETS

Answers to Review Questions 1. Wealth is a stock variable, meaning that it is measured at a point in time. For instance, a person might say, ―As of today, I have $2,000 in my savings account.‖ By contrast, saving is a flow variable, meaning that it is measured per unit of time. So, the same person might say, ―I save $20 per week.‖ Saving increases wealth at the rate at which saving takes place: If I add $20 per week to my savings account (and don‘t withdraw anything), the total wealth represented by the savings account will grow at a rate of $20 per week (it will equal $2020 next week, $2040 the week after, and so on).

Wealth also rises when the values of the assets held by an individual rise; such increases are called capital gains. So, if I own $2000 in stock, and stock prices rise by 1 percent, my wealth rises to $2020 even if I do no saving. As pointed out in the text, the major reason for the increased wealth of U.S. households during the1990s was capital gains since the U.S. household saving rate was quite low.

2. First, life-cycle saving is saving for long-term objectives, as when a couple saves for their retirement or for tuition for their children. Second, precautionary saving is saving for emergencies, as when the same couple puts part of their income aside in anticipation of the possibility that one of them might be laid off or become ill. Third, bequest saving is saving to leave an inheritance (bequest), to one‘s children for example, or to a worthy cause.

Psychological factors relevant to saving include self-control and demonstration effects.

Because people may have problems with self-control, saving may be enhanced by the availability of saving vehicles like retirement accounts, into which payroll deductions are placed automatically and from which withdrawals are difficult. Demonstration effects occur when people observe others around them spending at a high level and are thereby motivated to spend more (and save less) as well.

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3. National saving is defined as Y – C – G, where Y is real output (GDP), C is consumption spending, and G is government purchases of goods and services. This definition fits the general concept of saving, which is current income minus spending on current needs. For a nation, we may think of national output as current income, and spending on consumer goods and government purchases as spending on current needs. Note that investment spending (I), which is spending on the productive capacity that will provide for future needs, is not subtracted when we define national saving, as this is not spending on current needs.

Strictly speaking however, neither all of consumption spending (C), nor all of government spending (G), is for current needs. Consumption spending includes spending on consumer durables, which are useful for more than one period; and government purchases include purchases of public capital goods, such as roads, school buildings, and military hardware.

Thus, the standard definition of national saving, Y – C – G, probably overstates the amount of current spending and understates the true amount of saving in the economy.

4. Low household saving rates are not necessarily a problem for the economy as a whole. The reason is that national saving, not household saving, represents the pool of resources available for capital formation. National saving includes business saving and government saving as well as household saving, so low rates of household saving can be offset by higher rates of business and/or government saving. However, the fact that many households save very little (and do not own shares of businesses, e.g., through stockholdings) is a problem for those households, as they will find themselves with low levels of wealth. With low wealth, low-saving households will find it difficult to attain objectives like a comfortable retirement and will be poorly protected against economic emergencies.

5. The ―demanders‖ of saving are firms investing in new capital goods. The higher the real interest rate that firms must pay to borrow, the less profitable their proposed capital investments will be, and the less they will choose to borrow. Thus, the higher the cost of funds (as measured by the real interest rate), the lower the quantity of saving demanded.

6. Examples of factors that increase the supply of saving are an increase in the government budget surplus (government saving) or an increase in thriftiness among households. Either change increases the amount of saving done at each real interest rate. In the savinginvestment diagram, an increase in saving shifts the saving curve to the right, raising the quantities of saving and investment and lowering the real interest rate.

An example of a factor increasing the demand for saving is a technological improvement that makes capital investments more productive. As investment becomes more profitable, firms will demand more funds in financial markets at each real interest rate, so that the investment curve shifts to the right. As a result, the equilibrium quantities of saving and investment increase, and the real interest rate increases as well.

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Answers to Problems 1. a. Corey‘s initial balance sheet: ASSETS Mountain bike Cash Baseball card Checking acct. balance TOTAL

LIABILITIES $300 Credit card debt $200 Electric bill due $400 $1,200 $2,100

$150 $250

$400

Corey's net worth is equal to total assets minus total liabilities, which equals $1,700. b. The card is worth zero rather than $400. Assets decline to $1,700, liabilities are unchanged, and net worth falls by $400 to $1,300. This is an example of a capital loss; no saving (positive or negative) has occurred. c. Liabilities are reduced by $150, assets are unchanged, and net worth increases by $150 to $1,850. Note that paying off a debt out of current income is a form of saving. d. Assets decline by $150 as the checking account balance falls from $1,200 to $1,050. Liabilities also decline by $150, as the credit card debt falls to zero. Net worth (assets minus liabilities) is unchanged. No saving has been done in this case; rather an existing asset was set off against an existing liability. Only the events described in part c correspond to saving on Corey‘s part.

2. a. Flow: GDP represents production per unit of time, such as a year or a quarter. b. Flow: National saving is measured per unit of time, analogous to individual saving. c. Stock: This value is measured at a point in time. d. Stock: Again, the value is measured at a point in time. e. Flow: The deficit is the government‘s spending over the course of a year less its receipts over the course of a year. f. Stock: The quantity of government debt outstanding is measured at a point in time.

3. a. For life-cycle reasons (anticipation of future childcare expenses or tuition), Ellie 79 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

and Vince will probably increase their current saving. There is also the possibility that in the future one or both parents may work less in order to be at home. To prepare for the possibility of reduced income in the future, the couple should save more today. b. Vince‘s risk of layoff has increased, so the couple should increase their saving for precautionary reasons. c. More saving is needed to meet a life-cycle objective. d. More saving is needed for a life-cycle objective; as the couple faces a reduction in their income and the need to pay tuition expenses in a few years, they need to save more now. e. Less saving is needed to meet the life-cycle objective of retirement. f. For bequest reasons, the couple should save more

4. a. Suppose Sarah deposits the $10,000 in an IRA. At 5 percent interest, the $10,000 bonus is worth ($10,000) × (1.05) in one year, ($10,000) × (1.05) × (1.05) = ($10,000) × (1.05)2 in two years, and up to five years when it is worth ($10,000) × (1.05)5 = $12,763. After Sarah withdraws the amount, she must pay 30 percent in taxes, leaving her with (0.7) × ($12,763) = $8,934 after taxes.

If Sarah does not use the IRA, she will have to pay a 30 percent tax on the bonus in the year that she receives it, leaving her $7,000 to invest. She must also pay 30 percent of her interest income in taxes each year, so that the actual interest she will receive will be 70 percent of 5 percent, or 3.5 percent after taxes. In five years, her investment will be worth ($7,000) × (1.035)5 = $8,314. She owes no further taxes on the withdrawal.

Comparing the two scenarios, Sarah ends up with $8,934 after taxes if she deposits her bonus in her IRA, and $8,314 if she does not. The IRA is therefore a good deal for Sarah. b. (1) Empirically, a higher real return seems to increase saving modestly. This suggests that the higher real interest rate available with IRA accounts, where savers do not pay taxes on their annual interest earnings, has a positive (if small) effect on saving.

(2) From a psychological perspective, the fact that funds cannot be withdrawn from an IRA prior to retirement (except at a substantial penalty) may make it easier for people to exert self-control. So IRAs tend to raise saving on account of this as well.

5. a. Public saving = Government budget surplus = Tax collections – Transfers and interest payments – Government purchases = 245 – 135 – 260 = -150 Private saving = Household saving + Business saving = 200 + 400 = 600 80 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

National saving = Private saving + Public saving = 600 + -150 = 450.

National saving rate = National saving/GDP = 450/3,000 = 15%. b. Public saving = Government budget surplus = 100 Private saving = Total income – Net taxes – Consumption = Total income – (Tax collections + Transfers and interest payments) – Consumption = 6,400 – 1,925 + 400 – 4,570 = 305 National saving = Private saving + Public saving = 100 + 305 = 405 National saving rate = National saving/GDP = 405/6,400 = 6.3% c. Using the relationship Y = C + I + G + NX GDP (Y) = 4,800 + 1,000 + 1,000 + 16 = 6,816.

National saving = Y – C – G = 6,816 – 4,800 – 1,000 = 1,016.

Public saving = Government budget surplus = Tax collections – Transfers and interest payments – Government purchases = 1,700 – 500 – 1,000 = 200 Since public saving plus private saving equals national saving, private saving must be 816.

National saving rate is 1,016/6,816 = 14.9% 6. a. Ellie and Vince‘s ownership costs equal their general expenses (maintenance, taxes, and insurance) plus their mortgage interest costs. General expenses are 4 percent of $200,000, or $8,000 per year; and interest expenses are 6 percent of $200,000, or $12,000 per year; so the total ownership cost is $20,000 per year. This exceeds the cost of renting ($1,500 per month for 12 months, or $18,000), so Ellie and Vince should rent rather than buy.

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b. If Ellie and Vince are willing to pay $2,000 per month, or $24,000 per year, to rent, then they are better off buying the house (the cost of buying is lower than the cost of renting an equivalent house). c. If the real interest rate is 4 percent, then interest costs are 4 percent of $200,000, or $8,000; and total ownership costs are $16,000, which is less than the $18,000 Ellie and Vince are willing to pay for rent in part a. They should buy the house. d. If the value of the house is $150,000, then general expenses are 4 percent of $150,000, or $6,000; and interest costs are 6 percent of $150,000, or $9,000; so total ownership costs are $15,000. Since Vince and Ellie would be willing to pay $18,000 to rent a comparable house, now they should be willing to buy. e. As we saw in parts a & c, in general, higher interest rates meant that less people buy new houses, and more people prefer to rent existing houses. Naturally, home-building companies dislike that. As we saw in part d, home-building companies can still make people buy rather than rent, even when interest rates are high, by reducing house prices— but they dislike that too.

7. a.

Number of screens

Total patrons

Additional patrons (marginal product)

1 2 3 4 5

40,000 75,000 105,000 130,000 150,000

40,000 35,000 30,000 25,000 20,000

Value of marginal product $80,000 $70,000 $60,000 $50,000 $40,000

The marginal product declines as screens are added, illustrating diminishing returns to capital. b. The interest cost of each screen is (5.5%) × ($1,000,000) = $55,000. There are no other costs mentioned. The value of marginal product exceeds $55,000 for 3 screens but not 4, so 3 screens should be built. c. The value of marginal product exceeds the interest cost (7.5% of $1,000,000, or $75,000) for only the first screen. One screen will be built. d. At 10 percent interest, the interest cost of a screen is $100,000, more than the value of the marginal product of even the first screen, so no screens will be built. Parts b through d illustrate that capital investment (and, consequently, the demand for saving) falls as the real interest rate rises.

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e. The value of the marginal product of the fifth screen is $40,000. At an interest rate of 5.5 percent, building five screens is profitable only if 5.5 percent times the per-screen construction cost is no greater than $40,000. So, we can find this cost as follows: Cost per screen × 0.055 = $40,000 Cost per screen = $40,000/0.055 = $727,273 That is, the construction cost would have to be $727,273 per screen or less in order to make the five-screen complex profitable.

8. a. The investment tax credit effectively lowers the price of new capital goods to the firm by 10 percent. Firms‘ willingness to invest increases, raising the demand for saving (I). The real interest rate and the equilibrium quantities of investment and national saving rise as the demand for saving (I) curve shifts to the right. b. Increased public saving raises national saving. The supply of saving (S) curve shifts to the right. The real interest rate falls and the equilibrium quantities of investment and national saving rise. c. Increased productivity of new capital goods makes investment more profitable. The demand for saving (I) curve shifts to the right, raising the real interest rate and the equilibrium quantities of investment and national saving. d. The increased tax on corporate profits reduces the after-tax return to capital investments. Firms become less willing to invest, so that the demand for saving (I) shifts leftward. Public saving is unchanged by assumption, so the supply of saving curve (S) does not shift. The real interest rate and the equilibrium quantities of investment and national saving all decline. e. Increased precautionary saving raises national saving. The supply of saving (S) curve shifts to the right. The real interest rate falls and the equilibrium quantities of investment and national saving rise. f. An increased cost of capital decreases a firm‘s willingness to invest, lowering the demand for saving (I). The real interest rate and the equilibrium quantities of investment and national saving fall as the demand for saving (I) curve shifts to the left.

CHAPTER 17

MONEY, THE FEDERAL RESERVE, AND GLOBAL FINANCIAL MARKETS

Answers to Review Questions

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1. Money refers to any asset that can be used in making purchases (for example, cash and checking account balances). People hold money despite its lower return precisely because of its usefulness in transactions; a person who held no money and wanted to make a purchase would either have to resort to time-consuming barter or else incur the costs of selling other assets to obtain money.

2. If the public reduces it currency holdings in favor of bank deposits by $1 billion, banks will have an extra billion dollars in reserves, assuming that the Fed takes no action. Banks will then lend out these reserves, initiating a many-round process of lending and re-deposit in the banking system. Ultimately bank deposits will grow to an amount equaling bank reserves divided by the reserve/deposit ratio; so if the reserve/deposit ratio is less than one, bank deposits will be larger than bank reserves. The increase in deposits will outweigh the decline in currency held by the public, leading to an overall increase in the national money supply.

3. In a banking panic, depositors rush to withdraw their deposits from the banking system.

With deposit insurance, which protects the full value of deposits, people have no reason to make panicky withdrawals; however, prior to the introduction of deposit insurance, a bank failure could mean that depositors lost all their savings. Thus, news or rumors that a bank might fail (go bankrupt) prompted panics. Even a bank that made sound loans had reason to fear a panic; because bank reserves are only a fraction of deposits (the system of fractionalreserve banking), a large enough panic could lead any bank to run out of cash and be forced to close.

4. First, the financial system provides information about alternative investment opportunities, helping to allocate saving to the most productive uses. For example, banks specialize in evaluating the prospects of borrowers, on behalf of the depositors whose funds are being lent.

Similarly, professional stock and bond analysts investigate the potential returns of companies seeking funding, directing resources to the most attractive opportunities. Second, financial markets help savers share the risks of individual investment projects, as when an individual saver is able to diversify across a wide variety of stocks.

5. He will receive $1,000 for the bond only if the current one-year interest rate equals the coupon rate (the rate promised when the bond was issued). For example, suppose that the coupon rate and the current one-year rate are both 6%. Then the holder of the bond will receive $1,060 (principal plus coupon payment) on maturation of the bond in one year. If the current one-year interest rate in the financial market is 6%, another financial investor will be willing to pay Arjay $1,000 today for the bond, as it will be worth $1,060 (1.06 times $1,000) in one year.

However, if the coupon rate is greater than the current one-year interest rate, the bond is worth more than $1,000 today. For example, if the coupon rate is 7% and the current market rate is 6%, the holder of the bond will receive $1,070 in one year, which is worth $1,070/1.06

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= $1,009 today. Similarly, if the coupon rate is lower than the market rate, the bond is worth less than $1,000 today.

6. Stock values are fairly volatile and so carry a risk premium. In other words, the typical investor will hold stocks only if she expects to earn a higher return on average holding stocks than holding a safer asset, such as government bonds. If the relative riskiness of stocks does not bother you, then stocks are a good financial investment because of the higher return that you can expect to earn (on average, but not for certain) by holding them.

7. A capital inflow leads to funds flowing into a country, which in turn can be used for domestic investment in new capital goods. A capital inflow allows a country whose productive investment opportunities are greater than domestic savings to finance those investment opportunities by borrowing from abroad, increasing the total amount of investment in new capital goods. Domestic countries who finance domestic capital formation largely through capital inflows must pay interest and dividends to the foreign lenders in the future, which could impose a future burden on the domestic country. However, the hope is that the investment in new capital goods will increase domestic productivity, allowing the borrowing country to pay back its loans and benefit from increased output and incomes as well. Capital outflows have the opposite effect on investment in new capital. A capital outflow leaves less domestic savings to finance investment opportunities, leading to less investment in new capital goods.

Answers to Problems 1. a. Cigarettes were used in exchange for goods and services, so they functioned as a medium of exchange. Since in prison price quotes were made in terms of cigarettes, they fulfilled the requirement as a unit of account. Finally, since prisoners hoarded cigarettes for future use, they were a store of value. b. Cigarettes are relatively durable (compared to alternatives in a POW camp such as chocolate bars) and low enough in value to be useful in small transactions (compared with highly valuable assets such as boots or blankets, where there is no way to purchase a small item or "make change"). Other advantages of cigarettes include their portability and their relative uniformity in value (for instance, a pair of boots in good condition would be worth much more than another pair in worse condition). c. Yes, a nonsmoking prisoner would certainly accept cigarettes as payment since he could trade them for something else that he wanted. This is similar to our use of paper money: we have no direct use for one-dollar bills, but we accept them because we can trade them for things that we do want.

2. a. After the 5,000,000 guilders are put into circulation the consolidated balance 85 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

sheet of Gorgonzolan commercial banks looks like the following (compare to Table 17.2): ASSETS Currency 5,000,000

LIABILITIES Deposits 5,000,000

b. The banks want to maintain a 20 percent ratio of reserves to deposits, so they lend out 80 percent of their cash (4,000,000 guilders). Their consolidated balance sheet becomes (compare to Table 17.3): ASSETS Currency 1,000,000 Loans 4,000,000

LIABILITIES Deposits 5,000,000

c. After the loaned-out funds are redeposited in the banking system the consolidated balance sheet looks like this (compare to Table 17.4):

ASSETS Currency 5,000,000 Loans 4,000,000

LIABILITIES Deposits 9,000,000

d. The banks want reserves equal to 20 percent of deposits, or 1,800,000 guilders.

They, therefore, lend out the ―extra‖ 3,200,000 guilders of currency in their vaults. After the proceeds of these loans are redeposited in the banking system the balance sheet is (compare Table 17.5): ASSETS Currency 5,000,000 Loans 7,200,000

LIABILITIES Deposits 12,200,000

e. The process will not end until reserves equal 20 percent of deposits. Since reserves at the end of each round equal 5,000,000, at the end of the process deposits must be 25,000,000 (= 5,000,000/0.20). To make assets equal liabilities, loans must be 20,000,000. The final balance sheet of the commercial banks looks like this (compare to Table 17.6): ASSETS Currency 5,000,000 Loans 20,000,000

LIABILITIES Deposits 25,000,000

Since the public holds no currency, the Gorgonzolan money supply consists exclusively of deposits. The final value of the money supply is therefore 25,000,000 guilders.

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3. Money supply = Currency held by the public + Bank reserves/Desired reserve-deposit ratio a. Deposits equal bank reserves/(desired reserve-deposit ratio) = $100/0.25 = $400.

The money supply equals currency held by the public + deposits = $200 + $400 = $600. b. Let X = currency held by the public = bank reserves. Then the money supply equals X + X/(reserve-deposit ratio); substituting what we know from the problem: $500 = X + X/0.25 $500 = 5X X = $100 Thus, currency and bank reserves both equal $100. c. Since the money supply equals $1,250 and the public holds $250 in currency, bank deposits must equal $1,000. If bank reserves are $100, the desired reserve-deposit ratio equals $100/$1,000 = 0.10.

4. In order to reach the target money supply of $44.1 billion, and assuming constant values for the currency held by the public, the deposits need to be increased in each year. In 1932, the deposits would have to become $39.28 billion ($44.1 billion – 4.82 billion), since the money supply consists of deposits and the currency held by the public. We then know that banks held 10.9% (0.109) of the deposits as reserves, so the reserves would have to be $4.28 billion (39.28 billion × 0.109). Likewise, in 1933, the deposits would have to grow to $39.25 billion ($44.1 – 4.85) and the reserves would have to be $5.22 billion (39.25 billion × 0.133).

In order to increase the bank reserves, the Fed would have had to conduct open market purchases to provide banks with additional reserves. The amount of extra reserves needed was $1.1 (4.28 – 3.18) billion in 1932 and $1.77 (5.22 – 3.45) billion in 1933.

5. The Federal Reserve is a government agency; it cannot make a profit. The Fed focuses on promoting public goals such as economic growth, low inflation, and the smooth operation of financial markets. The Fed also has the power to control and regulate banks in order to prevent bank panics, while also having the power to make loans to banks.

6. a. The principal amount is $1,000, the term is 3 years, the coupon rate is 6 percent, and the coupon payment is $60. b. At the end of the second year, the only remaining payment is the final $1,060 to be paid in one year. If the interest rate is 3 percent, the value of $1,060 one year from today is 87 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

$1,060/1.03 = $1,029. If the interest rate is 8 percent, the value of the bond today is $1,060/1.08 = $981. And if the interest rate is 10 percent, the value of the bond today is $1,060/1.10 = $964. c. It is possible that there is bad news about Amalgamated Corporation, leading financial investors to fear that the firm might go bankrupt and not pay off its debt in one year.

Thus, financial investors will shun the bond and look for alternative investments.

7. a. In one year, the stock will be worth $104.50 ($5.50 in dividends plus $99 when the share is sold). To obtain the share‘s value today, we need to consider the 5.1 percent safe rate of interest that is available on other financial investments. This means that the current stock price × 1.051 = $104.50, so the current stock price must be $104.50/1.051 = $99.43. b. The share is still worth $104.50 in one year, as it was in part a. Now, at the higher interest rate, the share‘s value today is $104.50 1.101 = $94.91. (Note: This confirms the discussion in the text: an increase in the interest rate lowers the stock price.) c. Again, the share is worth $104.50 in one year. Now the interest rate over the year is 7.1 percent (the 5.1 percent safe interest rate plus the 2 percent risk premium). The share‘s value today is therefore $104.50/1.071 = $97.57. (Note: This confirms the discussion in the text: an increase in the risk premium lowers the stock price.) d. Part a: The value of the stock in one year will be $99. Thus, the share‘s value today is $99/1.051 = $94.20.

Part b: The value of the stock in one year will be $99. Thus, the share‘s value today is $99/1.101 = $89.92.

Part c: The value of the stock in one year will be $99. Thus, the share‘s value today is $99/1.071 = $92.44.

(Note: This confirms the discussion in the text: all else equal, a lower expected dividend lowers the stock price.)

8. a. DonkeyInc pays 10 percent with a 40 percent probability, zero otherwise. The expected average return is 0.40 × 0.10 = 0.04, or 4 percent. ElephantInc pays 8 percent with a 60 percent probability, zero otherwise. The expected average return is 0.08 × 0.60 = 0.48, or 4.8 percent. To maximize expected return, you should invest all your funds in ElephantInc. b. If the Democrats win, your dollar return is $50 (10 percent of the $500 invested in DonkeyInc). If the Republicans win, your dollar return is $40 (8 percent of the $500 invested in ElephantInc). Since the Democrats win with a probability of 40 percent and the Republicans win with a probability of 60 percent, your expected dollar return is (0.40)($50) + (0.60)($40) = $44, or a 4.4 percent expected return on your $1,000 initial investment.

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c. The strategy in part b gives a lower expected return than the strategy in part a. However, the strategy in part a is riskier, since you receive nothing if the Democrats win. The advantage of the strategy in part b is that you receive a reasonable return no matter which party wins (that is, it is less risky, which compensates for the lower expected return). d. To achieve a guaranteed 4.4 percent return, you need a strategy that guarantees you at least $44 no matter who wins the election. If you invest $550 in ElephantInc and $450 in DonkeyInc, your return will be exactly $44 (8 percent of $550) if the Republicans win and $45 (10 percent of $450) if the Democrats win. e. Let D be the number of dollars you ―bet‖ on the Democrats and $1,000 – D be the number of dollars you bet on the Republicans. If the Democrats win you receive a dollar return of (10%)(D). If the Republicans win you receive a dollar return of (8%)($1,000 – D). You want these two returns to be equal: (10%)(D) = (8%)($1,000 – D) Solving for D: (10%)(D) + (8%)(D) = (8%)($1,000) (18%)(D) = $80 D = $80/(18%) = $444.44 The strategy is therefore to invest $444.44 in DonkeyInc and $555.56 in ElephantInc to guarantee a return of 4.4 percent no matter who wins.

9. a. The U.S. export creates a trade surplus (NX > 0). The purchase of Israeli stock is a capital outflow in the same amount (KI < 0). The capital outflow (negative inflow) just offsets the trade surplus. b. Here the U.S. import of oil creates a trade deficit (NX < 0). The Mexican purchase of U.S. government debt is a capital inflow to the United States (KI > 0), which offsets the trade deficit. c. In this case, the U.S. purchase of oil from Mexico is offset by the sale of drilling equipment to Mexico. Thus, the value of the imported oil is offset by the value of the exported drill equipment, leaving net exports unaffected. Therefore, there is no net capital inflow (KI = 0) as well.

10. a. An increase in investment opportunities (increasing the rate of return on

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investment projects) will shift the investment curve (I) to the right, which leads to an increase in investment and an increase in the domestic real interest rate. The increase in the real interest rate will lead to an increase in both domestic savings and capital inflows. b. An increase in the government budget deficit shifts the saving curve (S + KI) to the left, which leads to a decrease in investment and an increase in the domestic real interest rate.

The increase in the real interest rate will lead to an increase in the capital inflow, which will help to partially offset the decline in national saving brought about by the increase in the government budget deficit, but overall investment will decline. c. An increase in domestic saving will shift the saving curve (S + KI) to the right, which leads to an increase in investment and a decrease in the domestic real interest rate. The fall in the real interest rate will lead to a decrease in the capital inflow. d. If foreigners believe that the riskiness of lending money to the country has increased, this will shift the saving curve (S + KI) to the left, leading to an increase in the domestic real interest rate and a reduction in investment.

CHAPTER 18

SHORT-TERM ECONOMIC FLUCTUATIONS AND FISCAL POLICY

Answers to Review Questions 1. A recession is a period in which the economy is growing at a rate significantly below normal.

An expansion is a period in which the economy is growing at a rate significantly above normal. The beginning of a recession is called the peak (the point at which economic activity reaches its highest point and begins to decline), whereas the end point of a recession (and the beginning of the expansion) is called a trough. In the postwar United States, expansions have been considerably longer than recessions on average.

2. The term cycle implies a predictably recurring event. In fact, recessions and expansions are of irregular length and size. This irregularity makes forecasting peaks and troughs quite difficult.

3. In general, producers of durable goods are affected most by recessions while producers of nondurables (like food) and services are affected least. Automobiles are durable goods, so the automobile producer would probably see its profits reduced the most, while the janitorial service will see the smallest decline in profit. Boots and shoes are ―semi-durable‖ since a pair of shoes may last for several years and people can put off purchases of these for a while if 90 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

necessary. Thus the boot manufacturer‘s losses are likely to fall in between those of the other two firms.

4. The natural unemployment rate is the sum of structural and frictional unemployment and excludes cyclical unemployment. Hence, the natural unemployment rate by definition should not be affected by a recession. Also, by definition, the cyclical unemployment rate rises in a recession. Inflation tends to decline in the period following a recession. Finally, poll ratings of presidents tend to be strongly correlated with the state of the economy, so a recession will probably reduce a president‘s popularity.

5. Potential output, or potential GDP, is the maximum sustainable amount of output (real GDP) that an economy can produce. Because inputs can be used at greater than normal rates for a time (for example, workers can work overtime and machines can be used at night or on weekends), it is possible for the economy to produce an amount exceeding potential output in the short run.

6. False. A recession is a period of unusually slow growth. This could result from a recessionary output gap, but it could also result from slow growth in potential output, due to such factors as below-normal rates of technological innovation.

7. False. When output equals potential output, the unemployment rate equals the natural unemployment rate. Cyclical unemployment is zero when output equals potential output, but frictional and structural unemployment still exist.

8. The key assumption of the basic Keynesian model is that in the short run, firms meet demand at pre-set prices. The fact that firms produce to meet demand implies that changes in demand (and therefore aggregate spending) dictates the output level in the short run.

9. There are many possible examples. Goods that are standardized and are bought and sold in large quantities, such as wheat or other commodities, tend to have rapidly adjusting prices since the benefits of setting up active auction markets for such goods usually exceeds the costs. Goods such as dresses or skirts, which are not standardized (they vary in size, color, style) and which are usually sold in retail stores one by one, tend to have prices that are changed less frequently.

10. Aggregate expenditure (AE) is total spending on final goods and services. It includes consumer expenditures, investment spending, government purchases of goods and services, and net exports (exports less imports).

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A change in output alters the income received by producers, which in turn affects consumption spending through the consumption function. Since consumer expenditures is the largest component of AE, changes in output lead to changes in AE.

11. The multiplier tells us the effect of a one-unit increase in autonomous expenditure on shortrun equilibrium output. The multiplier is greater than one because a one-unit increase in autonomous expenditure directly increases output by one unit and increases producers‘ incomes by one unit. The increase in income leads to further spending on the part of producers, which raises income of other producers and subsequently increases their spending. This multiple-round process of spending and income creation leads to a final increase in output that is greater than the one-unit initial impact.

12. The increase in government purchases raises autonomous aggregate demand by 50 units. The tax cut raises disposable income by 50 units, which stimulates aggregate expenditure by increasing consumption spending. However, the tax cut raises autonomous expenditure by only 50 units times the marginal propensity to consume (MPC), as not all additional income is spent. As long as the MPC is less than one, the tax cut will increase autonomous expenditure by less than 50 units. Thus, the increase in government purchases will have the greater impact on aggregate expenditure.

13. First, government spending and taxing decisions may affect potential output as well as aggregate expenditure. What the government spends its money on, as well as the incentive effects of changes in tax and transfer programs, need to be factored in when evaluating the effects of fiscal policy. The type of spending may affect long-run growth of potential output, as well as how tax policies affect labor supply decisions and investment decisions.

Second, changes in government spending and taxing can affect the government‘s budget deficit, which in turn may affect long-run investment in capital goods and the growth of potential output. For example, an expansionary fiscal policy may boost aggregate expenditure in the short run, leading to increased output and employment, but it may also raise real interest rates if it reduces national saving (by increasing the government‘s budget deficit without an offsetting increase in private saving). The increased interest rates may reduce capital investment and long-run growth of output.

Third, fiscal policy is relatively inflexible, with long legislative processes reducing the government‘s ability to quickly respond to output gaps. The delays in implementation may stem from the legislative process itself (budget recommendations are first presented to Congress by the President, then are often debated for months before finally becoming law, and may take effect months after this) or from political wrangling over spending and taxing priorities

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1. The 14 previous expansions lasted a total of 900 months, or a little over 64 months per expansion. The minimum duration of an expansion in the United States was 12 months (July 1980-July 1981), while the maximum duration was 128 months (June 2009 – February 2020).

There is mild evidence that expansions are getting longer: The first seven expansions in the table averaged 54 months, while the last seven averaged about 74 months each.

There seems to be no particular tendency for long expansions to be followed by long recessions: The 106-month expansion that began in February 1961 was followed by an 11month recession and the 120-month expansion that began in March 2001 was followed by an 8-month recession.

2. Data on real GDP and the growth rate of real GDP during the 1981-82, 1990-91, and 2001 recessions are given in the table below:

Year/quarter

1981q1 1981q2 1981q3 1981q4 1982q1 1982q2 1982q3 1982q4 1990q2 1990q3 1990q4 1991q1 2000q4 2001q1 2001q2 2001q3 2001q4 2007q4 2008q1 2008q2

GDP Growth rate from (billions of preceding quarter 2005 dollars) 1981-1982 recession 6,005.7 -0.8% 5,957.8 6,030.2 1.2% 5,955.1 -1.2% 5,857.3 -1.6% 5,889.1 0.5% 5,866.4 -0.4% 5,871.0 0.1% 1990-1991 recession 8,059.6 8,059.5 0.0% 7,988.9 -0.8% 7,950.2 -0.5% 2001 recession 11,334.5 11,297.2 -0.1% 11,371.3 0.3% 11,340.1 -0.4% 11,380.1 0.4% 2007-2009 recession 14,991.8 14,889.5 -0.8% 14,963.4 0.5% 93

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2008q3 2008q4 2009q1 2009q2

14,891.6 14,577.0 14,375.0 14,355.6

-0.5% -2.3% -1.5% -0.1%

a. In the 1981-82 recession, there were four quarters of negative real GDP growth (the 2nd and 4th quarters of 1981 and the 1st and 3rd quarters of 1982.) In the 1990-91 recession, there were two quarters of negative real GDP growth (the 4th quarter of 1990 and the 1st quarter of 1991.) In the 2001 recession, there were two quarters of negative real GDP growth (the 1st and 3rd quarters of 2001.) Finally, in the 2007-2009 recession, there were five quarters of negative real GDP growth (the 1st, 3rd, and 4th quarters of 2008 and the 1st and 2nd quarters of 2009). b. There were two consecutive quarters of negative real GDP growth in both the 1981-82, 1990-91, and 2007-09 recessions. The 2001 recession did not satisfy the informal criterion that a recession must have two consecutive quarters of negative GDP growth.

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3. The data from the problem along with the output gap, the type of gap and the growth rate of real GDP are given in the table below:

Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Growth rate of Real GDP Potential GDP Output gap Type of gap real GDP $14,234.2 $14,272.6 -0.3 expansionary $14,613.8 $14,578.7 0.2 expansionary 2.7% $14,873.7 $14,843.6 0.2 recessionary 1.8% $14,830.4 $15,098.3 -1.8 recessionary -0.3% $14,418.7 $15,310.3 -5.8 recessionary -2.5% $14,783.8 $15,457.0 -4.4 recessionary 2.5% $15,020.6 $15,615.8 -3.8 recessionary 1.6% $15,354.6 $15,815.5 -2.9 recessionary 2.2% $15,612.2 $16,049.4 -2.7 recessionary 1.7% $16,013.3 $16,305.7 -1.8 recessionary 2.6% $16,471.5 $16,573.4 -0.6 recessionary 2.9% $16,716.2 $16,832.8 -0.7 recessionary 1.5%

The growth rate of GDP was negative in 2005 but turned positive in 2006 and 2007. The growth rate of real GDP became negative again in 2008 and 2009, corresponding to the official dating of the last recession. Since 2010, the growth rate of real GDP has continuously been positive, but the recessionary gap has continued. This indicates just how long the effects of the Great Recession have been on the U.S. economy.

4. Here are the data for January 2021:

Both sexes, 16 to 19 years Men, 20 years and over Women, 20 years and over

Unemployment rate (percent) 14.8 6.0 6.0

Teenage unemployment rates are much higher than adult rates, reflecting the facts that teenagers are less skilled and are much less likely to take long-term stable jobs (i.e. they move frequently into and out of the labor force). One reason why the natural rate of unemployment has declined since 1980 is that the share of the labor force aged 16 to 19 has fallen, which has lowered the average rate of unemployment across the whole workforce.

5. When actual output is lower than its potential, there exists an output gap known as a recessionary gap. A low aggregate spending causes output to fall below potential output.

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Government policies, in this case expansionary policies can help to eliminate this type of output gap.

On the other hand, when spending is high, output may rise above potential output creating an output gap known as an inflationary gap. Government policies, in this case contractionary policies, can help to eliminate this type of output gap. Therefore, the statement that "Output gaps are caused by inflationary pressures generated by the unintended side effects of government policy" is not correct. Government policies do not cause and output gap, rather these policies are helpful in eliminating output gaps.

6. Keynes‘s account of the economy is built on a key assumption: In the short run, firms meet the demand for their products at preset prices. Firms do not respond to every change in the demand for their products by changing their prices. Instead, they typically set a price for some period, then meet the demand at that price.

7. a. Disposable income (before-tax income less taxes paid) and consumption are as follows: Before-tax income ($) 25,000 27,000 28,000 30,000

Taxes paid ($) 3,000 3,500 3,700 4,000

Disposable income ($) 22,000 23,500 24,300 26,000

Consumption ($) 20,000 21,350 22,070 23,600

The marginal propensity to consume is the increase in consumption caused by a one dollar increase in disposable income. In this case, when disposable income increases by from $22,000 to $23,500 (an increase of $1,500), consumption rises by $1,350. The mpc is therefore $1,350/$1,500 = 0.9. We can confirm this by checking the other points on the consumption function. For example, when disposable income rises by another $800 ($24,300 – $23,500), consumption rises by $720 ($2,070 – $21,350), which is (0.9)($800). Similarly, if disposable income rises by yet another $1700 ($26,000 – $24,300), consumption rises by $1,530 = (0.9)($1,700).

We can also find the intercept of the consumption function, C : Since the mpc is 0.9, we know the consumption function can be expressed as C  C  (0.9)(Y  T) . To find C , plug into the equation any of the numerical combinations of consumption and disposable income given above. For example, if we set C = $20,000 and Y – T = $22,000, we get $ 20,000  C  (0.9)($22,000) , which implies C  $200. The consumption function for the Simpsons is therefore C  $200  (0.9)(Y  T ) . b. From the consumption function derived in part a, setting Y = $32,000 and T = $5,000, C = $200 + (0.9)($27,000) = $24,500.

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c. The consumption function shifts upward by $1,000 at each level of disposable income (that is, the vertical intercept, C , rises from $200 to $1,200.) The mpc is unaffected because the increase in consumption is the same at each level of disposable income. This implies that the graph makes a parallel upward shift and the slope, equal to the mpc, does not change.

8. a. Aggregate expenditure is the sum of four components: consumer expenditures (C), firms' investment (I), government purchases (G), and net exports (NX) or C + I + G + NX. Substituting the components that are given in the problem, we get: Aggregate Expenditure = 40 + (0.8)(600 – 150) + 70 + 120 + 10 = 240 + 0.8(450) = 240 + 360 = 600.

Note the short-run aggregate output (Y) is assumed to always be equal to aggregate spending, so aggregate expenditure must be the same as Y or 600.

b. If investment and the constant term in the consumption function are both lowered by 10, then the new value of aggregate expenditure = 30 + (0.8)(600 – 150) + 60 + 120 + 10 = 240 + 0.8(450) = 220 + 360 = 580. c. Firms will respond to this decrease in aggregate expenditure from 600 to 580, by lowering their production of output (Y) to 580—meeting demand or expenditure at existing prices. This reduction in output and the use of resources will reduce aggregate income further, which affects the consumption function where households will respond to a lower income level by reducing their consumption even further. Notice that the value of household consumption is now 30 + 0.8(580 – 150) or 374 instead of the 390 that households spent directly after their initial reduction of 10. Additional reductions in output, income, and expenditure will therefore follow as the initial reduction in expenditure is multiplied. d. In order to offset this initial drop in consumption and investment expenditure in the amount of 20, government purchases should be increased by the same amount, or 20. One can think of this fiscal policy action as the government replacing the missing private spending with additional public spending. e. Since reductions in aggregate expenditure are multiplied as described above in part c, increases in aggregate must likewise be multiplied. So as far as the amount of extra or additional expenditure needed, this value of 20 will not change whether the increase in government purchases comes before or after the reduction in expenditure starts to multiply throughout the economy.

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f. Since only MPC, or in this case 80%, of any increase in disposable income will be spent (the remaining 20% is saved), a tax cut will increase aggregate expenditure less than an increase in government purchases of the same amount. So if the government decides to change taxes to avoid a recession, then taxes would need to change by more than 20 (the answer to part d and e). In fact, taxes would have to be reduced by 25, since 80% of 25 is 20. Note that tax cuts are multiplied just as much as increases in government purchases— it is just the initial change or the value being multiplied that is different.

9. a. If fiscal policy is just as likely to impact a nation‘s actual GDP as its potential GDP, then fiscal policy will not effectively close output gaps since both the target value (Y*) and the archived value (Y) changes. This complication in the use of fiscal policy is referred to as the supply side qualification. b. If recessions are short while fiscal policy is slow, then fiscal policy will often be help that arrives only after the problem is already fixed. This drawback or qualification in the use of fiscal policy is known as the relative inflexibility of fiscal policy. c. For different reasons, including political ones, governments may favor the use of expansionary fiscal policy of contractionary policy. This practice will lead to persistent budget deficit and increasing debts. This is known as the deficit problem or qualification in the use of fiscal policy.

10. Automatic stabilizers are provisions in existing laws that imply automatic increases in spending when real output decrease, or vice versa. Or explained differently, these are stabilizing tools that do NOT require any additional actions from the government.

Note that all the statements above are examples of automatic stabilizers except for a change in the marginal income tax rate, which would require a new action by the government. Examples include: increased income tax revenues due to average incomes going up during an expansion; reduced unemployment rates during an expansion means more people working, and the government pays less out in food assistance; and increased unemployment cause the government to pay out more in unemployment insurance boosting household income.

CHAPTER 19

STABILIZING THE ECONOMY: THE ROLE OF THE FED

Answers to Review Questions 1. The demand for money is the amount of money that an individual or other wealth-holder chooses to hold; the economy-wide demand for money is the amount of money held by all wealth-holders taken together. Because a higher nominal interest rate increases the opportunity cost of holding money (funds not held in the form of money could be earning interest), the demand for money falls when the nominal interest rate rises. Increases in the 98 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

price level or income tend to increase the dollar volume of transactions, increasing the benefit of holding money and thus the demand for money.

2. Equilibrium in the market for money is shown in Figure 19.3. The nominal interest rate is determined at the intersection of the downward-sloping demand for money curve and the vertical supply curve for money (as established by the Fed). The Fed can affect the nominal interest rate by changing the supply of money and thus shifting the supply curve of money (see Figure 19.4.) An increase in the supply of money shifts the vertical supply curve for money to the right, lowering the nominal interest rate, while a reduction in the money supply shifts the supply curve to the left and raises the nominal interest rate.

The real interest rate is the nominal interest rate minus the rate of inflation. Because the rate of inflation adjusts relatively slowly, the Fed can control the real interest rate in the short run.

However, in the long run the Fed cannot control the real interest rate; rather, in the long run the real interest rate is determined by the equality of saving and investment.

3. In an open-market purchase of bonds, the Fed uses newly created money to buy government bonds from the public. This action lowers the nominal interest rate, as can be seen in two ways:  First, the purchase of bonds raises the demand for and hence the price of bonds. Since bond prices are inversely related to nominal interest rates, an increase in bond prices is equivalent to a decline in interest rates.  Second, an increase in the money supply shifts the money supply curve to the right, lowering the nominal interest rate that clears the market for money. In economic terms, people are willing to hold more money only if the opportunity cost of doing so—which is the nominal interest rate—declines.

4. Discount window lending: When individual commercial banks are short of reserves, they may choose to borrow reserves from the Fed, using, one for the Fed‘s discount window programs. Loans of reserves by the Fed directly increase the quantity of reserves in the banking system, providing liquidity to financial institutions, and keeping interest from increasing, e.g., during times of market stress.

Setting and Changing Reserve Requirements: By increasing banks‘ reserve requirements, the Fed could, in principle, increase interest rates, and by lowering reserve requirements it could decrease interest rates. Notice however that banks may choose to keep their reserve-deposits ratio higher than the Fed-mandated reserve requirements.

5. Quantitative easing: The Fed can purchase longer-term assets, such as longer-term government bonds. This will increase their price and decrease longer-term interest rates.

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Forward guidance: The Fed can announce that it is going to keep short-run interest rates at zero for an extended period of time. This will tend to lower longer-term interest rates because the implied commitment that short-term borrowing will remain ―cheap‖ also in the future will also make it ―cheaper‖ to borrow from now until that future.

6. In no particular order:  A higher real interest rate increases the reward for saving; if people save more in response to a higher real interest rate, than they are necessarily consuming less.  A higher real interest rate makes it more costly to finance consumer durables and housing, reducing spending on those items.  Firms will purchase fewer new capital goods when the real interest rate is high because the cost of borrowing (or the opportunity cost of retained earnings) used to finance capital goods purchases is high.

Thus, a higher real interest rate is likely to reduce both consumption and investment spending, both of which are components of planned aggregate expenditures.

7. The Fed is likely to respond to a recessionary gap with an expansionary monetary policy intended to stimulate aggregate expenditure. The first step is an open-market purchase of government bonds, which puts additional money into circulation and lowers the nominal interest rate. The lower nominal interest rate results in a lower real interest rate in the short run since inflation is slow to change. The lower real interest rate stimulates both consumption and investment spending, leading to an increase in aggregate expenditure. Finally, the increase in aggregate expenditure raises short-run equilibrium output since output equals aggregate expenditure in the short run.

8. If the Federal Reserve takes a contractionary policy action (such as an open-market sale of government bonds), we would expect the Federal Reserve to raise nominal (and therefore real interest rates in the short run) by reducing the money supply. An increase in the real interest rate will reduce autonomous expenditures in the economy, leading to a reduction in short-run equilibrium output. The Fed would most likely undertake such a policy in order to bring the economy back to full employment when it was experiencing an expansionary gap.

9. The Fed has less precise knowledge of the economy than suggested by the numerical examples of this chapter. For example, at any given time the Fed does not know exactly the size of the output gap, the precise magnitude of the effect of a change in the interest rate on aggregate demand, or the time needed for the full impact of a policy change to be felt. For these reasons monetary policy is sometimes called ―as much an art as a science,‖ and the Fed tends to be cautious in its actions.

Answers to Problems 100 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

1. a. The money demand curve shifts to the right, as people demand more money for transaction purposes.

b. If the Fed took no action, money supply would remain unchanged and the nominal interest rate would rise. c. During the Christmas season, the Fed provides increases in the money supply in order to accommodate increased shopping needs without an increase in the interest rate.

Graphically, the vertical money supply curve is shifted to the right enough to just offset the effect of the rightward demand shift on the nominal interest rate, as seen in the graph below.

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2. a. Here is a table that shows Uma‘s average money holdings and the extra benefit of holding money: Average money holdings $500 $600 $700 $800 $900 $1,000 $1,100 $1,200

Total benefit $135 $147 $157 $165 $171 $175 $177 $177

Extra benefit --$12 $10 $8 $6 $4 $2 0

Uma should compare the extra benefits from increasing her money holdings to her opportunity cost of holding more money and increase her money holdings as long as the benefit of doing so exceeds the cost.

The cost of holding an extra $100 is the interest that she could have earned in some alternative financial investment. So if the nominal interest rate is 9%, the cost of holding an extra $100 is 9% of $100, or $9 per year. The extra benefit of moving from $600 to $700 in money holdings exceeds $9 (see the table), but the extra benefit of moving from $700 to $800 in money is less than the cost. Thus, if the interest rate is 9%, Uma should hold $700. Similarly, if the interest rate is 5%, the cost of holding an additional $100 is $5, and Uma should hold $900 in money. Finally, at an interest rate of 3%, the cost of each extra $100 in money is $3, and extra benefits exceed costs up to a holding of $1,000. b. Following the logic from part a, the table below illustrates Uma‘s demand for money at select nominal interest rates Nominal interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Quantity of money demanded $1,100 $1,100 $1,000 $1,000 $900 $900 $800 $800 $700 $700 102

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11% 12%

$600 $600

Graphing the quantity of money demanded as a function of the nominal interest rate will lead to a downward-sloping money demand function, with the nominal interest rate on the vertical axis and the quantity of money demanded on the horizontal axis. As the interest rate falls, the quantity of money demanded increases.

3. a. Lower commission charges reduce the cost of converting non-money assets, such as stocks and bonds, into money. People will tend to hold less money, knowing that it is relatively cheap to sell other assets to obtain money as needed to make transactions, so the economy-wide demand for money will decline. b. People will start to charge their groceries instead of using money (cash or check). A checking balance is still necessary in order to pay the credit card bill at the end of the month, but the overall effect is likely to be to reduce the amount of money people need to hold on average over the month. The demand for money will therefore be lower than it was before grocery stores started accepting charge cards. c. If stocks become more risky, people will demand relatively more safe assets, money among them. The demand for money therefore will increase.

4. a. If the Fed lowers the discount rate and increases discount lending, it will provide commercial banks with more excess or lendable reserves. This will increase the money supply in the economy, which in turn lowers the cost of borrowing money—nominal interest rates. b. If the Fed increases the reserve requirement for commercial banks, then commercial banks with be required to hold back a large portion of their reserves and therefore reduce their excess or lendable reserves. This will decrease the money supply in the economy, which increases the cost of borrowing money—nominal interest rates. c. If the Fed conducts open market sales of government bonds to the public, it will collect money from the public in return for the bonds that the Fed is selling. This will decrease the money supply in the economy, which increases nominal interest rates. d. If the Fed decreases the reserve requirement for commercial banks, then commercial banks will be required to hold back a smaller portion of their reserves, which increases their excess or lendable reserves. This will increase the money supply in the economy, which decreases the cost of borrowing money—nominal interest rates.

5. All other things equal, one can predict that this action will decrease required reserves, which means an increase in the portion of lendable or excess reserves. With more excess reserves, 103 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

commercial banks will have an incentive to increase the amount of loans generated. In order to attract more borrowers who can borrow these excess reserves, commercial banks will decrease the cost of borrowing funds or the interest rates in the nation.

6. This action by the Chinese central bank to reduce the required reserve-deposit ratio from 18.5 percent to 18 percent is the same as increasing the money multiplier from 1/0.185, or 5.4054 to 1/0.18, or 5.5556; 0.15 increase in the money multiplier. With bank reserves constant at 4,329 billion yuan, the bank‘s deposits will change from 23,400 billion yuan (4,329 × 1/0.185) before the change to 24,050 billion yuan (4,329 × 1/0.18) after the change in the reserve-deposit ratio.

With bank reserves constant at 4,329 billion yuan the bank‘s deposits will change by 650 billion yuan (24,050 – 23,400).

7. While discount lending is part of the conventional monetary policy tool available to the Fed, forward guidance, quantitative easing, and interest on reserves are all tools available to the Fed when the federal funds rate is already at, or close to zero.

8. Lending to their customers as well as earning interest on reserves deposited with the Fed are two profitable alternative uses for a commercial bank's reserves. In other words, the interest that banks receive from the Fed on excess reserves represents an opportunity cost for banks when lending to their borrowers. Therefore, a higher rate from the Fed will require a higher reward for banks when lending to their customers. Note that the Fed does NOT lend directly to households or businesses, so any excess reserves deposited with the Fed represent funds made unavailable for lending.

9. a. Aggregate expenditure and output (Y) is given by: Y = C + I + G + NX Y = [260 + 0.8(Y – 300) – 1,000r] + (200 – 1,000r) + 180 + 0 Y = 260 + 200 + 180 – 0.8(300) + 0.8Y – 2,000r Y = 640 – 240 + 0.8Y – 2,000r Y – 0.8Y = 400 – 2,000r 0.2Y = 400 – 2,000r Y = (400 – 2,000r) / 0.2 Y = 2,000 – 10,000r b. Since r = 0.10, then Y = 2,000 – 10,000(0.1) Y = 2,000 – 1,000 Y = 1,000 c. Since r = 0.12, then 104 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Y = 2,000 – 10,000(0.12) Y = 2,000 – 1,200 Y = 800 d. Since r = 0.08, then Y = 2,000 – 10,000(0.08) Y = 2,000 – 800 Y = 1,200

10. a. If the real interest rate is 10% (0.10), then Y = 5,800 – 12,000(0.10) Y = 5,800 – 1,200 Y = 4,600 Since the actual output is 4,600 is greater than the potential of 4,000, this economy is experiencing an expansionary output gap. b. If the real interest rate is 20% (0.20), then Y = 5,800 – 12,000(0.20) Y = 5,800 – 2,400 Y = 3,400 Since the actual output is 3,400 is less than the potential of 4,000, this economy is experiencing a recessionary output gap. c. To eliminate output gaps and achieve its potential, the Fed should set the real interest rate at a value that makes Y = Y* = 4,000.

Y = 5,800 – 12,000r 4,000 = 5,800 – 12,000r 12,000r = 5,800 – 4,000 12,000r = 1,800 r = 1,800 / 12,000 r = 0.15, or 15% 11. a. If π = 0.04 and the output gap is +0.01, we can plug these values into the Taylor rule to obtain r = 0.01 + 0.5(0.01) + 0.5(0.04) = 0.01 + 0.005 + 0.02 = 0.035 = 3.5%. So, the real interest rate implied by the Taylor rule when inflation is 4 percent, and the output gap is +1 percent is 3.5 percent. The nominal interest rate equals the real interest rate plus the inflation rate, or 3.5% + 4% = 7.5%.

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b. If π = 0.02 and the output gap is -0.02, we can plug these values into the Taylor rule to obtain r = 0.01 + 0.5(-0.02) + 0.5(0.02) = 0.01 – 0.01 + 0.01 = 0.01 = 1%. Note that whenever the inflation rate and a negative output gap has the same percent value, then the real interest rate implied by the Taylor rule is simply the constant value 0.01, or 1 percent.

The nominal interest rate equals the real interest rate plus the inflation rate, or 1% + 2% = 3%. c. If π = 0.06 and there is no output gap, we can plug these values into the Taylor rule to obtain r = 0.01 + 0.5(0) + 0.5(0.06) = 0.01 + 0 + 0.03 = 0.04 = 4%. So the real interest rate implied by the Taylor rule when inflation is 6 percent and there is no output gap is 4 percent. The nominal interest rate equals the real interest rate plus the inflation rate, or 4% + 6% = 10%. d. If π = 0.02 and the output gap is -0.05, we can plug these values into the Taylor rule to obtain r = 0.01 + 0.5(-0.05) + 0.5(0.02) = 0.01 – 0.025 + 0.01 = -0.005 = -0.5%. So the real interest rate implied by the Taylor rule when inflation is 2 percent and the output gap is -5 percent is negative 0.5 percent. The nominal interest rate equals the real interest rate plus the inflation rate, or -0.5% + 2% = 1.5%.

Note that negative real interest rates are a reality whenever the nominal interest rate is smaller than the rate of inflation. In part d, we see a nominal interest rate of 1.5 percent and an inflation rate of 2 percent, which would yield a negative interest rate of 0.5 percent. Note that the term ―unconventional monetary policy tools" refer to efforts to reduce the nominal interest rate below zero, and not the real interest rate.

12. With inflation being 0.02 (2%) and the output gap estimated at -0.02 (-2%), we can plug these values into the Taylor rule to obtain r = 0.01 + 0.5(-0.02) + 0.5(0.02) = 0.01 – 0.01 + 0.01 = 0.01 = 1%.

Note that whenever the inflation rate and a negative output gap is the same percent, the real interest rate implied by the Taylor rule is simply the constant value 0.01, or 1 percent. The nominal interest rate equals the real interest rate plus the inflation rate, or 1% + 2% = 3%.

Since the Fed was holding the federal funds rate at 1.75% in 2002, the actual interest rate was 1.25 percent (3 – 1.75) lower than what the Taylor rule predicts.

13. In practice, the Fed's information about the level of potential output and the size and speed of the effects of its actions is imprecise, and the potential output can be estimated only approximately.

In practice, it appears that monetary policy is an art and a science. Scientific analysis, such as the development of detailed statistical models of the economy, have proved useful in making monetary policy. But human judgment based on long experience—the art of monetary 106 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

policy—is likely to continue to play a crucial role as monetary policy continues to be widely used across modern economies.

CHAPTER 20

AGGREGATE DEMAND, AGGREGATE SUPPLY, AND INFLATION

Answers to Review Questions 1. The aggregate demand (AD) curve shows the relationship between the inflation rate and short-run equilibrium output in the economy. As the inflation rate rises, the Federal Reserve raises the real interest rate, which reduces autonomous expenditure and in turn, short-run equilibrium output. Therefore, along the AD curve, as the inflation rate rises, the output level falls, leading to a downward-sloping curve (with inflation on the vertical axis and output on the horizontal axis).

There are four other factors listed in this chapter that could lead to this downward slope: (1) inflationary effects on wealth and consumption, (2) inflationary effects on the redistribution of income and wealth, which in turn affect consumption, (3) inflationary effects on investment spending, and (4) inflationary effects on net exports (for a given exchange rate).

2. a. An increase in government purchases raises aggregate demand and short-run equilibrium output. Thus, an increase in government purchases shifts the AD curve to the right. b. Because it leads consumers to spend more, a cut in taxes stimulates aggregate demand at each level of inflation, shifting the AD curve to the right. c. A decline in autonomous investment spending by firms reduces aggregate demand at each level of inflation, shifting the AD curve to the left. d. For each level of inflation, a lower real interest rate stimulates consumption and investment spending, raising aggregate demand and output. Thus, an easier policy by the Fed shifts the AD curve to the right.

3. Prices of commodities are set continuously in auction markets and therefore can adjust quickly to changes in supply or demand. However, most prices are not determined in auction markets but are set only periodically. In setting prices or wages for a longer period, individuals‘ expectations of future inflation are important; the higher is expected inflation, the higher the future wage or price must be set in order to maintain the desired level of purchasing power. But expectations of inflation in turn depend in part on recent experience with inflation. So, we have a vicious (or virtuous circle), as high inflation leads to high 107 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

expectations of inflation, which in turn leads to high actual inflation (and the reverse if inflation is low). Together with long-term contracts that ―lock in‖ prices and wages for a period of time, expectations of inflation contribute to inflation inertia, or ―stickiness‖.

4. Expansionary gaps tend to raise inflation, and recessionary gaps tend to reduce it. If an expansionary gap exists, for example, firms are producing above normal capacity.

Eventually they will respond by attempting to raise their relative price (that is, raising their own price faster than the rate of inflation). As all firms try to do this, inflation will tend to speed up. Likewise, a recessionary gap implies that firms are producing below normal capacity. To stimulate demand for their products, firms will try to reduce their relative prices, leading to an overall slowdown in inflation.

Graphically, the link between output gaps and inflation is captured by movements of the short-run aggregate supply (SRAS) line. If an expansionary gap exists at the current intersection of the SRAS line and the AD curve (which determines short-run equilibrium output), inflation rises and the SRAS line moves upward. If a recessionary gap exists in short-run equilibrium, inflation falls and the SRAS line moves downward. Inflation and the SRAS line adjust until the economy reaches long-run equilibrium at the intersection of the AD curve and the long-run aggregate supply (LRAS) line.

5. Short-run equilibrium occurs at the intersection of the AD curve and the SRAS line. When short-run equilibrium output is greater than potential output (that is, equilibrium is to the right of the LRAS line), an expansionary gap exists. The expansionary gap leads inflation to rise over time; the SRAS line, which shows the current rate of inflation, therefore also rises over time. The SRAS line continues to rise until it intersects the LRAS line and AD curve at point B. At point B, called the long-run equilibrium point, output equals potential output and the inflation rate is stable. (See Figures 20.5, 20.6, and 20.7 in the text).

6. The answer is ambiguous, as whether stabilization policy is useful depends largely on the speed at which self-correction takes place. The more slowly the economy adjusts, the more likely it is that stabilization policy will be useful. Thus, if the economy has many long-term contracts or other barriers to rapid adjustment, or if the economy is initially far from full employment, then stabilization policy is more likely to be useful.

7. During the 1960s expansionary fiscal policy (military expenditures for the Vietnam War, the Great Society) increased aggregate demand. This increase in demand was for the most part not offset by monetary policy, so that inflation resulted. During the 1970s, inflation shocks— large increases in the prices of energy and food—were the main source of inflation increases.

8. An adverse inflation shock (which shifts the SRAS line upwards) both raises inflation and creates a recessionary gap (with higher unemployment). Policymakers can respond only through monetary or fiscal policies that shift the AD curve. If they expand aggregate demand, 108 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

shifting the AD curve to the right, they offset the recessionary impact but accept the higher rate of inflation permanently. If they do nothing, allowing the economy to self-correct, the surge in inflation will ultimately be eliminated but only at the cost of a potentially protracted recession and high unemployment. Thus, an inflation shock creates a difficult dilemma for policymakers.

9. Assume for concreteness that the economy starts at full employment, but with an inflation rate higher than the Fed would like. To reduce inflation, the Fed tightens monetary policy, shifting the AD curve leftward. In the short run inflation is unchanged (the SRAS line has not shifted), output is lower (a recession), and the real interest rate is higher (tighter money means that the Fed raises the real interest rate at any given level of inflation). The recessionary gap implies that over time inflation will fall; graphically, the SRAS line shifts downward until long-run equilibrium is restored at the intersection of the AD curve, the LRAS line, and the SRAS line. In the long run inflation is lower and output returns to full employment. The real interest rate declines as inflation falls; indeed, in the long run it returns to its original full-employment value, consistent with equilibrium in the market for saving and investment.

10. Moderate and high rates of inflation can impose significant costs to the economy, in particular with respect to long run growth. Low and stable inflation helps reduce uncertainty for businesses and helps to encourage greater investment, which in turn leads to higher productivity and faster growth of potential output (higher standards of living). High and moderate inflation has been shown empirically to retard economic growth, thus policymakers attempt to keep inflation low, even though at times following this policy may lead to shortrun costs in terms of higher unemployment and lower output.

Answers to Problems 1. With the relationship between short-run equilibrium output and the real interest rate r set by the Fed being: Y = 1,000 – 1,000r, we can compute the short-run equilibrium output for any value of r. Using the reaction function shown in the table, we can thereby compute the shortrun equilibrium output for any rate of inflation.

For example, when the rate of inflation is 0, the real rate of interest is set at 0.02 (2%).

Using the equation: Y = 1,000 – 1,000r, we find that Y = 980 [= 1,000 – (1,000 × 0.02) = 1,000 – 20].

Rate of Inflation (%) 0 1

Real interest rate, r Equilibrium, Y 0.02 980 0.03 970 109

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2 3 4

0.04 0.05 0.06

960 950 940

The aggregate demand (AD) curve shows the relationship between short-run equilibrium output (Y) and the rate of inflation.

2. With the relationship between short-run equilibrium output and the real interest rate r being: Y = 1,000 – 1,000r, we can solve the equation for r when output is at potential or 960: 960 = 1,000 – 1,000r 1,000r = 1,000 – 960 r = 40/1,000 r = 0.04 So potential output is reached when the real interest rate r set by the Fed is 0.04, or 4 percent, which according to the Fed's reaction function in the table corresponds with a rate of inflation of 2 percent.

Alternatively, one could solve for output for all the inflation levels given in the table and then find the inflation rate that corresponds to the output level of 960.

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3. a. In the short run, the equilibrium inflation rate and output level are given by the intersection of the SRAS and AD curves. Algebraically, the short-run equilibrium level of output is found by substituting the current inflation rate into the AD equation. With the relationship between short-run equilibrium output and rate of inflation (π) being: Y = 13,000 – 20,000π, we can compute the short-run equilibrium output for the rate of inflation of 0.04, or 4 percent.

Y = 13,000 – 20,000(0.04) Y = 13,000 – 800 Y = 12,200 b. In the long run, the equilibrium inflation rate and output level are given by the intersection of the LRAS and AD curves. Algebraically, the long-run equilibrium inflation rate is found by substituting the level of potential output into the AD equation.

With the relationship between short-run equilibrium output and the rate of inflation (π) being: Y = 13,000 – 20,000π, we can solve the equation for π when output is at potential or 12,000: 12,000 = 13,000 – 20,000π 20,000π = 13,000 – 12,000 π = 1,000/20,000 π = 0.05, or 5 percent So potential output is reached when the rate of inflation is 5 percent.

4. a. In the short run, the equilibrium inflation rate is simply the current inflation rate.

With the relationship between short-run equilibrium output and rate of inflation (π) being: Y = 1,000 – 10,000π, we can compute the short-run equilibrium output for the rate of inflation of 0.10, or 10 percent: Y = 1,000 – 1,000π Y = 1,000 – 1,000(0.01) Y = 1,000 – 100 Y = 900 Thus, the economy is experiencing a recessionary gap, since Y < Y*.

In the long run, the equilibrium output level is the level of potential output. With the relationship between short-run equilibrium output and the rate of inflation (π) being Y = 1,000 – 1,000π, we can solve the equation for π when output is at potential or 950: 950 = 1,000 – 1,000π 1,000π = 1,000 – 950 π = 500/10,000 111 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

π = 0.05 So potential output is reached when the rate of inflation is 5 percent. b. For the first quarter in the table, the difference between potential and actual output (Y* – Y) is 50 (950 – 900).

Then using the formula: next quarter's inflation = current quarter's inflation – 0.0004(Y* – Y), and the information that the current quarter's inflation rate is 0.10, the next quarter's rate of inflation will be 0.08 [= 0.1 – 0.0004(50)].

The actual output in the next quarter is then found using the equation Y = 1,000 – 1,000π, where π = 0.08. Therefore, Y = 920 [= 1,000 – 1,000(0.08)]. For the second quarter in the table, the difference between potential and actual output (Y* – Y) is 30 (= 950 – 920).

Then using the formula: next quarter's inflation = current quarter's inflation – 0.0004(Y* – Y), and the information that second quarter's inflation rate was 0.08, the next rate of inflation will be 0.068 [= 0.08 – (0.0004 × 30)]. The actual output in the following quarter is then found using the equation Y = 1,000 – 1,000π, where π = 0.068. The new Y = 932 [=1,000 – (1,000 × 0.068)].

The same procedure is then repeated for each additional quarter. The results are shown in the following table: Quarter 0 1 2 3 4 5

Inflation Rate 0.100 0.080 0.068 0.061 0.057 0.054

Y 900.0 920.0 932.0 939.2 943.5 946.1

Y* 950 950 950 950 950 950

Y* – Y 50.0 30.0 18.0 10.8 6.5 3.9

For each consecutive quarter in the table above, the rate of inflation starts coming closer to its long-run value of 0.05 (or 5 percent) as computed in part b. For the final quarter in the table, the rate of inflation will reach 0.054, which is fairly close to the long-run value.

At the same time, the difference between Y* and Y is decreasing from its original value of 50 to 3.9, indicating that the economy is moving closer to its potential output level of 950.

5. a. An increase in autonomous consumption shifts the AD curve to the right. In the short-run, this causes an expansionary gap with a higher inflation rate and output above its potential level of output. Since economy is now above its potential output level, inflationary expectations will rise and this will shift the SRAS curve up. Output will return to potential, but the inflation rate will be higher than it was initially.

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b. A reduction in taxes will increase consumer spending, shifting the AD curve to the right.

In the short-run, this causes an expansionary gap with a higher inflation rate and output above its potential level of output. Since economy is now above its potential output level, inflationary expectations will rise and this will shift the SRAS curve up. Output will return to potential, but the inflation rate will be higher than it was initially.

c. Loosening monetary policy shifts the AD curve to the right. In the short-run, this causes an expansionary gap with a higher inflation rate and output above its potential level of output. Since economy is now above its potential output level, inflationary expectations will rise and this will shift the SRAS curve up. Output will return to potential, but the inflation rate will be higher than it was initially.

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d. A sharp drop in oil prices is a favorable inflation shock that shifts the SRAS curve down.

In the short-run, this causes an expansionary gap with output above its potential level of output but a lower inflation rate. If the reduction in oil prices is seen as permanent, the economy's potential output level will eventually also increase. This is seen as a rightward shift of the LRAS in the long-run graph. So the economy's output is now at a new potential, but the inflation rate will lower than it was initially.

e. An increase in government purchases shifts the AD curve to the right. In the short-run, this causes an expansionary gap with a higher inflation rate and output above its potential level of output. Since economy is now above its potential output level, inflationary

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expectations will rise and this will shift the SRAS curve up. Output will return to potential, but the inflation rate will be higher than it was initially.

6. Initially the economy is at equilibrium at a level of output Y1 (point A), which is lower than the potential output Y*, and so a recessionary gap exists. If the government takes no action, inflation will fall and output will rise from Y1 to Y*. This is illustrated by the horizontal shortrun aggregate supply curve (SRAS) shifting down to the point where aggregate demand (AD) and the vertical long run aggregate supply (LRAS) meet at the potential output level Y*. This is illustrated in the diagram on the left below.

Note that this self-correction could also take place if the government takes a late action due to legislative delays. This would mean that 18 months later, at the time the tax cut starts taking effect, the economy is already at full employment. The tax cut will shift the AD curve to the right, and will cause the economy to ―overshoot‖ full employment, leading to an expansionary gap with higher output. This is illustrated in the diagram on the right below.

Note that this outcome would require additional adjustments to SRAS to restore the economy to its long-run equilibrium.

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7. The economy is initially in long-run equilibrium at point A when it is hit by an adverse inflation shock, shifting SRAS up to a higher rate of inflation and a lower level of GDP. As potential GDP is also reduced due to this permanent change, illustrated by LRAS shifting left, a new long-run equilibrium is established at a higher level of inflation and lower level of GDP. Note that the AD curve is unchanged as long as the government does not engage in policy response.

The economy is initially in long-run equilibrium at point A when it is hit by a permanent adverse inflation shock, shifting SRAS up and LRAS left. If the Fed responds by tightening monetary policy, the AD curve will shift to the left creating a recessionary gap at the new potential output level and higher inflation rate. Eventually, the SRAS will shift back down in 116 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

response to the recessionary gap, and the economy will return to full employment at the new lower Y* but at the original inflation rate. Note that the Fed in this situation is forced to choose a temporary recession over increased inflation to reach this long-run outcome. This is problem represents the hard choices that the Fed had to make in 1970s as oil prices and the rate of inflation both started increasing dramatically.

8. a. If the Fed eases its monetary policy, shifting its policy reaction function down, this will reduce the real interest rate associated with a given level of inflation. Thus, for any given level of inflation, there will be an increase in autonomous expenditure (due to the Federal Reserve reducing interest rates), shifting the AD curve to the right. Shifting the AD curve to the right to close the recessionary gap. The benefit is a faster reduction in the unemployment rate and increased output level, however, the cost is that the inflation rate will not decrease from its current level, rather than falling in response to the recessionary gap.

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b. If the Fed does not change its target rate of inflation and follows its current monetary policy rule, the economy will have a recessionary gap for a longer time. In other words, the cost of the Fed not taking any action to reduce interest rates, is that unemployment rates will be higher and output will be lower for a longer period (the cost). However, over time, the inflation rate will fall as firms lower their nominal prices and SRAS will shift down, leading to a move down and to the right along the AD curve. The economy will eventually return to a long-run equilibrium at potential GDP, with a lower inflation rate than in part a (the benefit).

CHAPTER 21

EXCHANGE RATES AND THE OPEN ECONOMY

Answers to Review Questions

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1. A dollar can be traded for either 110 yen or 10 pesos. Therefore 110 yen = 10 pesos. The yen-peso exchange rate can be expressed either as 11 yen/peso, or as 1/11 peso/yen (= 0.09 peso/yen).

2. The nominal exchange rate is the rate at which two currencies can be traded for each other.

The real exchange rate is the price of the average domestic good or service relative to the price of the average foreign good or service, when prices are expressed in terms of a common currency. A clear way to see how the two concepts are related is to use the formula for eP calculating the real exchange rate, f , where e is the nominal exchange rate, P is the P f domestic price level, and P is the foreign price level. The formula tells us that the real exchange rate is equal to the nominal exchange rate adjusted for the differences in prices across the two countries.

3. Crude oil: Yes, this is a standardized product with transportation costs that are low relative to its value.

Fresh milk: Probably not, as possible spoilage increases the cost of transporting it long distances.

Taxi rides: No, not traded internationally.

Music produced in different countries by local artists: No, they are not standardized goods.

4. U.S. households supply dollars in the foreign exchange market in order to obtain foreign currencies; they do this since they need foreign currencies to buy foreign goods, services, and assets. Similarly, foreign households demand dollars (in return for their domestic currency) in the foreign exchange market since they need dollars to purchase American goods, services, and assets.

5. An easing of monetary policy lowers the domestic real interest rate, which makes domestic financial assets less attractive to financial investors, including foreign investors. Foreigners demand less domestic currency, since they don‘t want to buy as many domestic assets, so there is a depreciation of the domestic currency (i.e. the value of the exchange rate falls.)

Depreciation makes imported goods and services more expensive relative to domestically produced goods and services, encouraging domestic residents to purchase fewer imports. In addition, exports will rise as the country‘s goods and services are more affordable to foreigners abroad. his increase in net exports increases planned aggregate expenditure, strengthening the effect of the easier monetary policy on output and employment. In general, under flexible exchange rates, changes in the exchange rate reinforce the effects of easing or tightening the money supply.

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6. An overvalued exchange rate is a fixed exchange rate whose official value exceeds its fundamental value, as determined by supply and demand in the foreign exchange market.

Ways to respond to overvaluation include devaluation, imposing restrictions on trade and capital flows, using international reserves to buy back the excess supply of domestic currency, and tightening monetary policy in order to increase the fundamental value of the exchange rate. Devaluation, or more generally, changing the value of the exchange rate whenever the fundamental value changes amounts to having a flexible exchange rate.

Imposing restrictions on trade and capital flows is bad for economic efficiency and growth.

Using international reserves only works until the central bank‘s reserves run out, after which the exchange rate may undergo a speculative attack. Using monetary policy to eliminate overvaluation may be the best approach, but it has the disadvantage that if monetary policy is used to support the fixed exchange rate, it is no longer available for stabilizing output and employment.

7. See Figure 21.7. In a speculative attack, financial investors sell domestic-currency assets, then supply the domestic currency they receive for these assets to the foreign exchange market. Thus, the supply curve for the domestic currency moves sharply to the right. In order to maintain the fixed exchange rate, the central bank must use its international reserves to buy the large quantity of its own country‘s currency flooding the foreign exchange market.

Hence its reserves are depleted more quickly. When the central banks international reserves are so low that it can no longer support the currency, a devaluation to the currency‘s fundamental value must result.

8. As discussed in Review Question 5, under a flexible-exchange-rate system the movement of the exchange rate tends to strengthen the ability of monetary policy to stabilize output. For example, a tight monetary policy raises the real interest rate and makes domestic assets more attractive to financial investors. The resulting increase in the demand for the domestic currency causes an appreciation, which makes it more difficult for domestic producers to export. The decline in net exports reinforces the negative impact of the tight monetary policy on output. In contrast, under fixed exchange rates, monetary policy must be used to keep the fundamental of the exchange rate near the official value, and thus it is no longer available to use for stabilization purposes.

Fixed exchange rates are more predictable than flexible exchange rates in the short run, as flexible exchange rates vary from moment to moment with shifts in supply and demand in the foreign exchange market. However, fixed exchange rates are subject to periodic speculative attacks, which can result in a large change in their value. So, in the long run, the value of an exchange rate that is currently fixed may be no more predictable than the value of a flexible exchange rate.

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Answers to Problems 1. From Table 21.1, 20.1091 pesos equal one dollar, and 105.29 yen equal one dollar.

Therefore, 20.1091 pesos = 105.29 yen.

Dividing both sides by 20.1091, we find an exchange rate of 5.236 yen/peso (one peso = 5.236 yen). Alternatively, dividing both sides by 105.29, we find that 0.191 pesos equal one yen, so the exchange rate is 0.191 pesos/yen. (We can get the same result by taking the reciprocal of 5.236.)

If the peso appreciates 10 percent against the dollar, then 20.1091 pesos buys 1.10 dollars.

So, the peso-dollar exchange rate is now 20.1091 /1.10 = 18.821 pesos to the dollar. Setting 18.821 pesos equal to 105.29 yen, we find the exchange rate to be 105.29/18.281 = 5.760 yen/peso, or 18.821/105.29 = 0.174 pesos/yen.

2. In dollars, the British automobile costs (£20,000)($1.50/£ ) = $30,000. The real exchange rate of the dollar, i.e. the price of the U.S. car relative to the British car is thus $26,000/$30,000 = 0.867, and clearly the U.S. car is cheaper.

From the British perspective, the value of the U.S. car in pounds is $26,000/($1.50/£) = £17,333. The real exchange rate of the pound— the price of the British car relative to the U.S. car—is £20,000/£17,333 = 1.154 (which is equal to 1/0.867). So, no matter which way we calculate it, we find that the British car is more expensive, and the U.S. car is more competitively priced.

You can also solve this problem by applying the formula for the real exchange rate,

e P .

Pf

However, you must be careful to apply the formula correctly to each country.

For Britain, the nominal exchange rate is the number of dollars per pound; therefore, the real exchange rate is:  $1.50     £ 20,000 e P  £    1.154 $26,000 Pf For the U.S., the nominal exchange rate is the number of pounds that can be purchased with one dollar; thus,  £1     $26,000 e  P  $1.50    0.867 £20,000 Pf

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3. Nominal Exchange Rate: Last year, $1 could buy 1/0.8 blue and $1 could buy 1/0.2 red. Therefore: 1/0.8 = 1/0.2.

Dividing both sides by 1/0.8, we get: 1/0.2 × 0.8 = 4 = the nominal exchange rate between red and blue last year.

Similarly, the nominal exchange rate between red and blue this year: 0.6/0.15 = 4.

Since the nominal exchange rate did not change between last year and this year, the percentage change = 0.

Real Exchange Rate:

e P , where e is the nominal exchange rate, P is the price level in Pf Blueland (domestic price), and Pf is the price level in Redland (foreign price).

The real exchange rate is

Substitute the values to calculate last year's real exchange rate: (4 × 100)/100 = 4.

Similarly, this year's real exchange rate: (4 × 120)/115 = 4.174.

The percentage change in Blueland's real exchange rate: (4.174 – 4)/4 × 100 = 4.348%.

As Blueland‘s real exchange rate with Redland appreciates, the relative price of its exports to Redland's increases. As a result, Blueland‘s exports to Redland will be hurt.

4. a. A country‘s real exchange rate is the price of the domestic good relative to the price of the foreign good, when prices are expressed in terms of a common currency. In U.S. dollars, the U.S.-made car costs $20,000 while the Japanese made car costs $25,000 (= ¥2,500,000 / ¥100 per dollar).

The real exchange rate of the dollar, i.e., the price of the U.S. car relative to the Japanese car is thus $20,000 / $25,000 = 0.8, so clearly the U.S. car is cheaper. Note that the answer would be the same if you used yen (¥) as the common currency: the U.S.-made car costs ($20,000 × ¥100 per yen) = ¥2,000,000, while the Japanese made car costs ¥2,500,000. The real exchange rate of the yen, i.e., the price of the U.S. car relative to the Japanese car is thus ¥2,000,000 / ¥2,500,000 = 0.8.

The net export of U.S.-made cars to Japan = U.S.-made exports – Japanese-made imports, where U.S. exports are the same as Japanese demand and U.S. imports are the same as U.S. demand. Japanese demand of U.S-made cars = 10,000 – 0.001(2,000,000.) = 10,000 – 2,000 = 8,000. U.S. demand for Japanese-made cars = 30,000 – 0.2(25,000) = 30,000 – 5,000 = 25,000. So the net export of U.S.-made cars to Japan = 8,000 – 25,000 = -17,000.

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b. When the nominal exchange rate changes from ¥100/$ to ¥125/$100, the U.S.made car still costs $20,000 while the Japanese made car now also costs $20,000 (¥2,500,000 / ¥125/$). The real exchange rate of the dollar, i.e. the price of the U.S. car relative to the Japanese car is now $20,000 / $20,000 = 1, so the U.S-made and Japanesemade cars are equally priced.

Note that the answer would be the same if you used yen (¥) as the common currency: the U.S.-made car costs ($20,000)(¥125/$ ) = ¥2,500,000, while the Japanese made car still costs ¥2,500,000. The real exchange rate of the dollar, i.e. the price of the U.S. car relative to the Japanese car is now ¥2,500,000 / ¥2,500,000 = 1. This mean that relative to the Japanese-made car, the U.S.-made car has increased in price due to the stronger, or appreciating dollar.

The new Japanese demand of U.S-made cars = 10,000 – 0.001(2,500,000.) = 10,000 – 2,500 = 7,500. U.S. demand for Japanese-made cars = 30,000 – 0.2(20,000) = 30,000 – 4,000 = 26,000. So the new net export of U.S.-made cars to Japan = 7,500 – 26,000 = 18,500.

When the U.S. dollar ($) appreciate relative to the Japanese yen (¥), then U.S.-made car increase in price relative to the Japanese-made car while the Japanese-made car becomes cheaper relative to the U.S.-made car. Using the law-of-demand, we would therefore expect fewer U.S.-made cars to be sold in Japan, thereby reducing U.S. exports while we would expect more Japanese-made car to be bought in the U.S, increasing U.S. imports.

The combined effect of lower exports and higher imports is of course a larger trade deficit with Japan when it comes to automobiles.

5. a. The purchasing power parity (PPP) theory, based on the law of one price, states that the price of an internationally traded commodity must be the same in all locations as long as transportation costs are relatively small. So the PPP theory can be used to find the nominal exchange rate between two currencies by setting the price of a commodity in one of the currencies equal to the price of the commodity in the second currency. Using the price of gold per ounce we find that $350 = 2,800 pesos, which means that $1 = 8 pesos (2,800/ 50). b. When Mexico experiences inflation so that the price of gold rises to 4,200 pesos per ounce, while it remains $350 per ounce in the United States, then $1 = 12 pesos (4,200/350).

According to the PPP theory, countries with higher inflation rates tend to experience the most rapid depreciation of their currencies.

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c. Using our answer to part b, we know that the exchange rate implied by the PPP theory is $1 = 12 pesos (4,200/350). If the price of crude oil is $30 per barrel in the United States, then according to the law of one price, the price of crude oil is 360 pesos ($30 × 12 pesos/$) per barrel in Mexico. d. Knowing that the exchange rate between the United States and Canada is 1 Canadian dollar = 0.70 U.S. dollars, we can easily compute that 1 U.S. dollars = (1/0.7) Canadian dollar. That implies that 350 U.S. dollars = $350/0.7 or 500 Canadian dollars. So an ounce of gold should cost 500 Canadian dollars in Canada.

6. a. When U.S. stocks are perceived to be riskier financial investments, American assets become less attractive and so the demand for dollars falls. The dollar depreciates. b. When European computer firms switch from U.S.-produced software to software produced in India, Israel, and other nations, the demand for U.S. goods (software) falls, so the demand for dollars falls. The dollar depreciates. c. When international investors become aware of new, high-return investment opportunities in East Asia, American assets become less attractive and so the demand for dollars falls.

Note that financial investors might also be switching funds from existing American assets to East Asian assets and thus they will supply more dollars to the foreign exchange market (in exchange for East Asian currencies). This will further depreciate the U.S. dollar.

7. a. We can convert the price of champagne in euros to the price in dollars by dividing the price in euros by the nominal exchange rate: (

)

b. Applying the same reasoning as in part a, (

)

c. The quantity of dollars supplied to the foreign exchange market will rise as the euro– dollar exchange rate rises. This is the essence of the supply curve in the foreign exchange market: domestic residents supply dollars in exchange for foreign currencies in order to purchase foreign goods, services, and assets.

8. a. We can convert the price of an iPod in dollars to the price in euros by multiplying the price in dollars by the nominal exchange rate: 1 euro $240   240 euros dollar 124 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

b. Applying the same reasoning as in part a, 0.8 euros $240   192 euros dollar c. The quantity of dollars demanded in the foreign exchange market will rise as the euro– dollar exchange rate falls. This is the essence of the demand curve in the foreign exchange market: foreign residents demand dollars in exchange for foreign currencies in order to purchase American goods, services, and assets.

9. When the government follows an easy monetary policy, it results in a lower real interest rate, but since this policy increases the supply of the currency, it depreciates. All this has a silver lining, a weak currency stimulates exports.

10. a. To find the fundamental value of the shekel, equate the demand and supply for shekels: 30,000 – 8,000e = 25,000 + 12,000e. Solving for e, we get 5,000 = 20,000e, or e = 0.25 (5,000/20,000) dollars per shekel. b.

At the official exchange rate of 0.3 dollars per shekel, the shekel is overvalued.

We already know that the fundamental value of one shekel is ―only‖ $0.25 but the official exchange rate sets the value of one shekel at $0.30 (or $0.05 too much). Therefore, there will not be enough shekels demanded to meet the quantity supplied at this valuation of 0.30 U.S. dollars per shekel.

We can compute the quantity of shekels demanded at e = 0.3 as: 30,000 – 8,000(0.3) = 30,000 – 2,400 = 27,600, and the quantity of shekels supplied as: 25,000 + 12,000 (0.3) = 25,000 + 3,600 = 28,600.

Thus, the quantity of shekels supplied to the foreign exchange market exceeds the quantity of shekels demanded by 1,000 (28,600 – 27,600) shekels. To maintain the existing fixed rate, the government of this nation must purchase 1,000 shekels per period to keep the market balanced, which is the nation‘s balance-of-payments deficit.

Since shekels are purchased at the official rate of 0.30 U.S. dollars per shekel, the balance-of-payments deficit in dollars is $300 (1,000 shekels × $0.3/shekel). Because a country with an overvalued exchange rate must use part of its international reserves to support the value of its own currency, over time its available reserves of foreign currencies will decline.

c. At the official exchange rate of 0.2 dollars per shekel, the shekel is undervalued by $0.05 per shekel. Therefore, there will not be enough shekels supplied to meet the quantity demanded at this valuation of 0.2 dollars per shekel.

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We can compute the quantity of shekels demanded at e = 0.2 as: 30,000 – 8,000(0.2) = 30,000 – 1,600 = 28,400, and the quantity of shekels supplied as: 25,000 + 12,000 (0.2) = 25,000 + 2,400 = 27,400.

Thus, the quantity of shekels demanded to the foreign exchange market exceeds the quantity of shekels supplied by 1,000 (28,400 – 27,400) shekels. To maintain the official value, the central bank must supply 1,000 shekels per period to keep the market balanced, which is the nation‘s balance-of-payments surplus.

Since shekels are sold at the official rate of 0.2 dollars per shekel, the balance-ofpayments surplus in dollars is $200 (1,000 shekels × $0.2 shekel). Because a country‘s central bank can print as much of its own currency as it likes, there is no danger of running out of international reserves with an undervalued currency. Indeed, the central bank‘s stock of international reserves will increase instead.

11. a. The fundamental value of the shekel can be found by equating the demand and supply functions for shekels: 30,000 – 8,000e = 25,000 + 12,000e. Solving for e, we get 5,000 = 20,000e or e = 0.25 (5,000/20,000) dollars per shekel. So at the official exchange rate of 0.3 dollars per shekel, the shekel is overvalued.

We can compute the quantity of shekels demanded at e = 0.3 as: 30,000 – 8,000(0.3) = 30,000 – 2,400 = 27,600, and the quantity of shekels supplied as: 25,000 + 12,000 (0.3) = 25,000 + 3,600 = 28,600.

Thus, the quantity of shekels supplied to the foreign exchange market exceeds the quantity of shekels demanded by 1,000 (28,600 – 27,600) shekels.

To maintain the existing fixed rate, the government of this nation must purchase 1,000 shekels per period to keep the market balanced, which is the nation‘s balance-ofpayments deficit. Since shekels are purchased at the official rate of 0.3 dollars per shekel, the balance-of-payments deficit in dollars is $300 (1,000 shekels × $0.3/shekel). This represents a decline by half of the available reserves of $600, so the year end reserve will equal $300 ($600 – $300). In other words, the country can maintain its fixed value of 0.30 U.S for this year as long as the foreign financial investors do not convert their shekel checking accounts into dollars. b. If foreign financial investors come to expect a possible devaluation of the shekel to 0.25 U.S. dollars, they are likely to initiate a sell-off of their domestic currency assets as a devaluation means that financial assets denominated in the domestic currency suddenly become worthless in terms of other currencies. In other words, they would want to convert their shekels into dollars, while they are still worth a total of $1,500 ($0.3/shekels × 5,000 shekels). c. If foreign financial investors withdraw all funds from their checking accounts and attempt to convert those shekels into dollars, there will be the need for an extra $1,500 in foreign 126 © 2022 by McGraw Hill. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

reserve at the existing exchange rate of $0.3/shekels. With the country's international reserves being only $600, the country will not be able to maintain the fixed value of 0.30 U.S for this year if the foreign financial investors decide to convert their shekel checking accounts into dollars. The currency will need to be devaluated. d. Since the action taken by the foreign investors, which was prompted by the mere fear of devaluation, will become the cause of an actual devaluation—this forecast of devaluation can be considered a ―self-fulfilling prophecy.‖

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